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In this topic we will discuss about: 
.Data Verification Sources
.Notice
.Essential Guidelines
.Discussions and cases about Merger and business valuations
Data Verification Sources 
1 = Theories and problems in financial management by M.Y khan and P.K Jain third edition
2 = Wikipedia the free encyclopedia (http://en.wikipedia.org/)
3 = www.investopedia.com
4 = Financial Management ACCA paper F9 by Kaplan
5 = CA module F Paper F 19 Business Finance Decisions

The term merger refers to the combination of two or more firms. The analysis of
financial aspects of merger covers three aspects

1. Determining the firm’s value

2. Financing techniques for merger
3. Merger as capital budgeting decision

Let us discuss each of them one by one

1. Determining the firm’s value

It is first step in merger it is difficult as different factors are considered in
conjunction with each other and book value itself is not an effective measure
itself as it is useful in specific situations. The importance of appraisal value
depends upon methods used to calculate it and nature of the business. The
market value is key element in evaluating the firm’s worth particularly in large
listed corporate firms. Another important criterion for merger decision is EPS.
However worth of a firm should not be determined on basic of a single approach
and a single figure but within a range after considering all the alternative
approaches

The EPS basic of determining the value of firm is based on the effect of merger
on the future EPS, that is, the EPS of the merged firm (EPS m) see this procedure
and its effect
EPSm = EATA + EATT / NA + NT

WHERE:

EATA = Earning after tax of the acquiring firm

EATT = Earning after tax of the target firm

NA = Number of equity shares outstanding of the acquiring firm

NT = Number of equity shares of the target firm

Market value of the merged firm Vm= EPSm * P/EA

Total gain from merger:

Vm = (VA – VT)

WHERE:

VA = EPSA * P/EA
VT = EPST * P/ET

Gain for Acquiring (GA) and Target (GT) firm

GA = [Post-merger value of firm A less Pre-merger value of firm A]

GA = [Post-merger value of firm T less Pre-merger value of firm T]

Approaches for valuations

There are three main approaches for business valuations mentioned under

1. DVM based on the return paid to the share-holders

= P 0 = [D 0 (1+g)] / [(K e – g)]

2. Income/earnings based - based on the returns earned by the firm

a. PE ratio method = value of

the company = total earning (NP after tax) * P/E ratio
b. Earning yield
= value
pe
r
 sh
are
=
EP
S
*
(1
/
ear
nin
g
yie
ld)
OR
= value of
sh
are
=
tot
al
ear
nin
gs
*
(1/
ear
nin
g
yie
ld)
While earning yield is simply inverse of P/E =
EPS / price per share
c. Discounted cash flow basic

3. Asset-based – based on the tangible assets owned by the company

4. ARR valuation method (value = (estimated annual profits / require return
on capital employed)
5. Supper profit valuation method = super profit = [actual profit - ( net book
value of tangible assets * avg. industry return)] and the company willing
to acquire mention that it will pay suppose for 3 years super profits in this
case the results of the above formula is multiplied with 3.
6. Additional promised amounts based on achievement of a certain level of
EAT
What is real worth of the company?
Valuation is described as an art not science; the real worth of the firm
depends on the viewpoints of the various parties and qualitative factors:

 The various methods of valuation will often give widely differing results
 It may be in interests of the investor to argue that either a high or low
value is appropriate
 The final figure will be a matter for negotiation between the interested
parties

2. Financing techniques for merger

Second aspect of the merger is Mode of Financing. In case of a firm having a
high P/E ratio, issue of equity shares is better, both to acquiring and target
firms.

To meet the investment needs of investors, convertible securities can be issued

yet another form of financing merger is the deferral payment plan

Tender offer is another alterative to acquiring a firm. The firm directly

approaches the shareholders of the target firm; this approach may be cheaper
provided the management of the target firm does not attempt to block it.

3. Merger as capital budgeting decision

If NPV of the decision is positive then go to merger, if NPV is 0 then it make no
difference in this case observe quantitative factors and if NPV is negative then
do not go for merger

NPV = P.V of all expected future cash inflows less P.V of cash paid

Cases:
 Formulas to remember

P/E ratio = Price / EPS

Price = (P/E ratio) * EPS

Comprehensive Case (Cases and solutions may contain

errors or omissions in such case please send feedback from home-page)

You have been provided the following financial data of the two companies

Firm A Firm T

Earning after taxes ($) 500 350

Equity shares outstanding 200 100
Earning par share ($) 2.50 3.50
P/E ratio 14 10
Market price per share ($) 35 35

Statement of financial position of the both companies is as under

Assets Firm A Firm T

($) ($)
Non-current Assets;

Plant and machinery 500 100

Furniture and fittings 50 50
Current Assets;

Cash 500 250

Debtors 150 100
Total Assets 1200 500
Equity and Liabilities
 Equity share capital ($1 200 100
each)
Retained Earnings 1000 125
Liabilities

Non Current Liabilities

14% Preference shares 0 25

13% debt ($ 5each) 0 250
Total Equity and Liabilities 1200 500

Required: (Do not try to relate any requirement with other one until
there is sure relationship as each case may be independent)

1. Determining the number of shares that will be issued for acquisition on

market price basic
2. What will be the post merger EPS?
3. What is the change is EPS for shareholders of both companies?
4. Determine the market value of the post merger firm assuming P/E
ratio of A remains unchanged
5. Ascertain the profit accruing to share-holders of both firms individually
6. What is the equivalent EPS for share-holders of T ltd if exchange ratio
is 0.8 shares of firm A in exchange for 1 share of firm T?
7. If firm A did not issue its shares but pay cash amounting 36.5 for each
share of T ltd then what will be the post-merger EPS?
8. What must be the exchange ratio so that Post and Pre-merger EPS of
Firm A should be equal?
9. If currently the firms defers the payment until three years after issuing
0.8 shares for one share of T ltd and post mergers earnings after tax
for Firm T are 300, 450 and 250 respectively then determine the
number of shares that should be issued each year for share-holders of
T ltd assuming P/E ratio for T ltd remains unchanged
10. Suppose firm T has unused losses of $3000 resulting from several
loss of incurred in the previous years and for tax purposes these losses
can be carried forward for 6 years and tax rate is 35% for income of
both companies and cost of capital for firm A is 20% then what is the
 net tax benefit to firm A by acquiring Firm T assuming same earnings
each year
11. Assuming 5% growth in EPS of Firm A and T is expected and Firm A is
contemplating to issue its shares in exchange of shares of Firm T
based on market price then what will be the exchange ratio? And how
much shares will be issued , and assuming no synergic gain, construct
a schedule of MPS with and without acquisition and determine that
how long it take to eliminate the dilution in EPS for share-holders of T
Ltd in the new firm?
12. What will be the capital structure after merger if A ltd issues shares
based on market price? What percentage the debt will be in new firm’s
capital, has the merged firm’s financial risk declined? And how much
additional debt the merged firm can borrow to maintain 50% debt in
capital structure?
13. If A ltd pays $2.50 for each share to share holders of firm T and also
issue shares in (1:1) then what is the true cost of acquiring further if
provided that the merger will result in cost savings of $1000 after 10
years and this saving will increase the market share price of merged
firm suddenly after merger if cost of capital for the firm merged firm is
20% then what is true cost of acquiring after considering further
information assuming P/E ratio of A ltd remains unchanged
14. Keeping in mind requirement 13th what is the Net benefit to the
shareholders of T ltd if market price is determined based upon P/E
ratio of A Ltd assuming unchanged?
15. As the annual earnings of T ltd are 350 keeping in mind only capital
structure of both companies and post merger weighted average cost of
capital of A ltd as 15% determine the maximum price that A ltd will be
willing to pay for one share of T ltd further assume that if the growth
of earning of T ltd is 20% for 2 years after merger and after that will
not grow further and each increase in cash flow will require $0.7
incremental investment in assets now based on the 12% pre-merger
cost what maximum price A ltd will be willing to pay? (round off your
answer to near decimal amount)
16. If firm A pays 50% dividend and firm T pays 60% dividend then
determine growth rate in dividends of both firms
17. Based on the data given in the balance sheet determine if the merger
is favorable or not while compiling after taking into considering that
company A is expecting sales of T ltd @700 for 5 years and debentures
will be settled by paying cash and cash amounting $1000 will be paid
to shareholders of T ltd with issuing 0.5 share of AT ltd in exchange
with one share in T ltd dissolution cost is $50 debtors are valued at
$90 and cost of capital for the company is 20% and corporate tax is
 30% for this case and salvage value of fixed assets is zero and P/E
ratio for Firm A will remain unchanged
18. By using DVM valuation approach determine the value of the firm T if
dividend this year is 50% of EPS and it was $1.496 before 4 years and
firm beta (b) is 0.8 while current market required rate of return (R m) is
equal to 6% and risk free rate (Rf) is 5%
19. As in requirement 18th you are provided that current payout ratio is
50% and beta is 0.8, current market return (Rm) is 6% and risk free
rate (Rf) is 5% if you were provided only these information along with
another information that rate of return on assets is10% then how will
you calculate value of the firm? (round off answer to nearest cent)
20. If you are provided that a firm similar to that T has earning yield of
12.5% then what is market value of firm T?
21. Suppose firm A is willing to acquire firm T on the super profit of 3
years and avg. return in industry for such type of firms is 50% then
what will be the amount payable? Further suppose that at this price
share-holders of T ltd are not willing to sell the shares then firm is
deciding to pay the extra amount if firm T be able to achieve a certain
level of EAT more details are as under
10% of average profit of 600 up to 800
12% of average profit of 800 up to 1000
15% of average profit of 1000 up to 1200
It is also estimated that probability of earnings are 30%, 15% and 5%
respectively
You are required to calculate total minimum and maximum gross
amount payable and expected amount payable based on probability
estimations

Solution:

1. Number of shares to be issued = 100 (1:1 as MP is same)

2. Post merger EPS ($)

(500 + 350) / (100 + 200) = 850 / 300 = 2.83

3. Change is EPS for shareholders of both companies ($)

Firm Firm T
Firm A
Pre-merger EPS 3.50
2.50
Post-merger EPS 2.83
2.83
Change [increase/ (Decrease)] (0.67)
0.33

4. Market value of the post merger firm assuming P/E ratio of A

remains unchanged ($)

Vm = EPS * P/E * S = 2.83*14*300 = 39.62 * 14 = 11886

WHERE:
S = Number of shares outstanding after issue [(100 + (200 *1)]

5. Profit accruing to share-holders of both firms individually (Gain

from merger) ($)
Post merger value of the firm 11886
Pre-merger value of the firm T (35*100) 3500
Pre-merger value of the firm A (35*200) 7000
Total 10500
Total Gain from merger 1386

Apportionment of gains
 Firm
A Firm B

New market value (MP * S) (39.62*200) (39.62*100) 7924

3962
Less: Old market value 7000
3500
Gain / (Loss) 924
462 = 1386

Alternatively:

(New Share market price of firm A less old share market price of form A)*
Number of shares (each firm)

Firm A = (39.62 less 35) * 200 = 924

Firm B = (39.62 less 35) * 100 = 462

THIS IS CALLED NPV OF MERGER

6. Equivalent EPS for share-holders of T ltd if exchange ratio is

(0.8:1)

Equivalent EPS = (Post-merger EPS * exchange ratio) = 3.04 * 0.8 = 2.43

WHERE:
Post merger EPS = [(500 + 350)] / [(200) + (100*0.8) = 850 / 280 = 3.04

7. Post-merger EPS if cash amounting 36.5 is paid for each share of

T Ltd.

Post merger EPS = [(500 + 350)] / [(100)] = 850 / 100 = 8.50

8. Exchange ratio so that Post and Pre-merger EPS of Firm T should

be equal
Suppose X represents the total number of ordinary shares issued to acquire Firm
T

(350 / 100) = [(350+500)/100+X)]

3.5 = 850 / 100+X
(100 + X)*3.50 = 850
3.50X = 850 less 350
X = 142.86

So total shares that should be issued are 142.86 for 200 shares and thus
exchange ratio is 0.71 shares (142.86/200) of Firm A for 1 share of firm T

9. Number of shares that should be issued for share-holders of T ltd

if earnings are 300, 450 and 250

Number of shares = EAT * P/ET / MVA

As: P/E = EPS/P and P = EPS*P/E and EPS = EAT/S Now P = (EAT/S)*P/E and V
= SP = (S*EAT/S)*P/E and V = EAT*P/E
WHERE: P = Market Price per share, S = no. of ordinary shares and V = value of
the firm

Where P/ET is Price earning of target firm and MVA = share market value of
acquiring firm
In contrast total value of the target firm in each year divided by market price
par share of acquiring firm in each year

Year
no. of shares to be issued

1 (300*10) / 35
85.71
2 (450*10) / 35
128.57
3 (250*10) / 35
71.43

10. Net tax benefit to firm A by acquiring Firm T when tax rate
is 35%
 EBIT (865/0.65) Accumulated Loss Taxable Income Tax Tax on normal income Gross Savi
1307 3000 0 0 457.45 457.45
1307 1693 0 0 457.45 457.45
1307 386 921 322.3 457.45 135.1
5
1307

Savings PV IF @20% P.V

457.45 0.833333333 381.2083333
457.45 0.694444444 317.6736111
135.1 0.578703704 78.18287037
777.0648148

11. Exchange ratio based upon market price per share

Market price per share of T / market price per share of A = 35/35 = 1 total
number of shares to me issued = 100*1 = 100
Total number of shares outstanding after issue = 200+100 = 300
New EPS = (350+500)/ (200+100) = 2.83

12. Schedule of EPS with and without Merger

Firm A Firm T Firm AT
Year EAT EPS EAT EPS EAT ($) EPS
($) ($) ($) ($) ($)
0 350.0 3.5 500.0 2.5 850.00 2.8
0 0 0 0 3
1 367.5 3.6 525.0 2.6 892.50 2.9
0 8 0 3 8
2 385.8 3.8 551.2 2.7 937.13 3.1
8 6 5 6 2
3 405.1 4.0 578.8 2.8 983.98 3.2
7 5 1 9 8
4 425.4 4.2 607.7 3.0 1,033.1 3.4
3 5 5 4 8 4
5 446.7 4.4 638.1 3.1 1,084.8 3.6
0 7 4 9 4 2

13. How long it take to eliminate the dilution in EPS?

Current EPS of Firm A is 3.5 and after merger it will took approximately 5 years
to eliminate dilution in EPS as in 4th year EPS will be 3.44 that is less than
current EPS (Before Merger) but in 5th year it becomes 3.62 that is greater than
current EPS (Before Merger) so it will be happen in 5th year
14. Capital structure after merger if A ltd issues shares based
on market price? Percentage the debt will be in new firm’s
capital, has the merged firm’s financial risk declined? And
Additional debt the merged firm can borrow to maintain 50%
debt in capital structure?
Total shares to be issued = 100 and total shares in the new firm = 300

New capital structure after issue

Assets
 
Non-current Assets;
 
Plant and machinery 600
Furniture and fittings 100
 
Current Assets;
 
Cash 750
Debtors 250
Good will 3275
 
Total Assets 4975
 
Equity and Liabilities
 
Equity share capital ($1 each) 300
14% Preference shares 25
Share Premium 3400
Retained Earnings 1000
 
Liabilities
 
Non Current Liabilities
 
 
13% debt ($ 5each) 250
 
Total Equity and Liabilities 4975
In the new firm financial risk as referred to A ltd increased and as referred to T
ltd decreases as to maintain 50% debt equity ratio company can increase debt
to 2362.50 (50% of equity) but currently company has 250 of debt which means
that company can issue $2112.50

15. True cost of acquiring

True cost of acquiring = (Cash paid + Market value of shares issued) less
market value of shares acquired (M.V of T firm)
True cost of acquiring = ((2.5*100) + (100*35)) less (100*35)
True cost of acquiring = $250

16. True cost of acquiring after considering further information

While calculating new share price the present value of the savings will be
^-10
considered so 1000(1.2) = 161.51 so the new share price will be
(Current earnings of firm A + current earnings of firm T + present value of
savings) / number of shares after merger
(350+500+162) /300 = 3.37

True cost of acquiring = (Cash paid + Market value of shares issued) less
market value of shares acquired (M.V of T firm)
True cost of acquiring = ((2.5*100) + (100*3.37*14)) less (100*35)
True cost of acquiring = $1472.67

Note: as the benefit is related to merger so its credit should be allocated to

merged firm

17. Maximum price that A ltd will be willing to pay for one
share of T ltd

Increase in CFAT from T ltd = 350 /0.15 = 2333

Total net value per share 2333/100 =
23.33

18. Maximum price that A ltd will be willing to pay for one
share of T ltd at 20% growth and incremental investment
Year CFAT Incremental Investment Net P.V.I.F @12% P.V ($)
 CFAT
1 350 0 350 0.892857143 313
2 420 49 371 0.797193878 296
3 504 58.8 445.2 0.711780248 317
3 504 0 504 8.333333333 4200
Maximum Value of the Firm 5125
20. Growth rate in dividend
Growth (G) = B*R (Retention ratio * ROI)

Firm A = (0.5 * 0.10) = 0.050 or 5%

Firm B = (0.4 * 0.07) = 0.028 or 2.8%

ROE of both firms

ROE = (EAT / Value of Equity funds)

ROE for firm A = (350 / 3500) = 0.10
ROE for Firm T = (500 / 7000) = 0.07

In some books ROI is calculated as (EAT / Net Tangible Assets)

21. Evaluation of merger considering balance sheet

Cost of merger; ($)

Cash payment 1000

Payment to debentures 250
Cost of dissolution 50
Market value of the shares issued 2800 (see attached
notes)
Total 4100

Financial Benefits from merger; ($)

Present value of cash flow after tax 1496 (see attached

notes)
Cash realized from T firm 250
Debtors value 90
Total 1836

Net benefit
Total benefits 1836
Less: total cost (4100)
Net 2264
No merger is not feasible, As present value is negative

Attached Notes:

Market value of the shares issued:

Post merger combined earnings / total number of shares outstanding

(500+500) / (50+200) = 4*14 = 56

Number of shares issued (100*0.5) = 50
Total value of the shares issued = 50*56 = 2800

Present value of net cash inflows

Sales 700
Less depreciation (100+50) /5 (30)
670
Less tax (30%) 201
Net profit after tax 469
Add back depreciation 30
CFAT 499 or approximately 500

Present value of CFAT = CFAT * PVIF@2% for 5 years = 500 *

2.991 = 1496

22. DVM valuation approach when two dividends are provided

Formula for current value of the share is

P 0 = [D 0 (1+g)] / [(K e – g)]

P 0 = [1.75 (1+0.04)] / [(0.058 – 0.04)]
P 0 = 101.11

Value of the firm = number of shares * value of share

Value of the firm = 100 * 101.11 = 10111.11

We have
D0 = (EPS*50%) = (3.5*0.5) =1.75

Will have to calculate Ke and growth rate (g)

By CAPM
Ke = Rf + b(Rm – Rf)
Ke = 0.05 + 0.8 (0.06 – 0.05)
Ke = 5.8%

And

^ 1/n
Growth (g) = [(current dividend / last mentioned dividend)] –1
^ 1/4
Growth (g) = [(1.75 / 1.496)] – 1 = 4%

22. DVM valuation approach when payout ratio is

provided
If payout ratio is provided then we can calculate growth by the formula BR
(retention * return on assets) so
Growth (g) = 0.5*0.1 = 0.05

And we know that

Formula for current value of the share is

P 0 = [D 0 (1+g)] / [(K e – g)]

P 0 = [1.75 (1+0.05)] / [(0.058 – 0.05)]
P 0 = 230

Value of the firm = number of shares * value of share

Value of the firm = 100 * 230 = 23000

23. Value of firm based on earning yield

Value of firm = Total net earning * (1/earning yield)
Value of firm = 350 * (1/0.125) = 2800

24. Value firm based on earnings and flotation cost

Cost of merger; ($)

Cash payment 1000

Payment to debentures 250
Cost of dissolution 50
Market value of the shares issued 56 (see attached
notes)
Total 1356

Financial Benefits from merger; ($)

Present value of cash flow after tax 2028 (see attached

notes)
Cash realized from T firm 250
Debtors value 90
Total 2368

Net benefit
Total benefits 2368
Less: total cost 1356
Net 1012

Yes merger is feasible as present value is positive

Attached Notes:

Market value of the shares issued:

Post merger combined earnings / total number of shares outstanding
(290+500) / (50+200) = 1.129
Number of shares issued (100*0.5) = 50
Total cost = 50*1.129 = 56

Present value of net cash inflows

Sales 400
Less depreciation (100+50) /5 (30)
370
Less tax (30%) 111
Net profit after tax 259
Add back depreciation 30
CFAT 289 or approximately 290

Effective Ke (EKe) = = [(1+Ke) / (1+flotation rate)] - 1

Effective Ke (EKe) = = [(1+0.2) / (1+0.05)] - 1
Effective Ke (EKe) = = 14.29%

Present value of CFAT = CFAT / EKe = 290 / 0.143 = 2028

 25. Supper profit valuation method

Super profit = [actual profit - (net book value of tangible assets * avg. industry
return)]
Super profit = [350 - (500 * 0.50)] = 100

Total payable amount = super profit * number of years for multiple

Total payable amount = 100 * 3 = 300

26. Total minimum and maximum gross amount payable

There are two probabilities 1st that firm will not achieve the target level on future
2nd that firm will be able to achieve the level weight of each probability is 50%
so minimum total payable amount is 300 when no extra gross amount to be paid
the maximum amount is that when firm succeed to achieve the maximum
earning level i.e. of 1200 then amount of 180(1200*0.15) plus initial 300 total
(480) will be payable

Expected amount payable based on probability estimations

First compute average expected amount with its probability and percentage of
payment

Lower Upper Average Probability Expected Payment Total Estimated Payment

Range Range Earning Percentage
600 800 700 0.3 210 10% 21
800 1000 900 0.15 135 12% 16.2
1000 1200 1100 0.05 55 15% 8.25
Total 45.45

Valuation of debt and preference shares

and other cases
Case 1:

A firm has issued $100 12% shares and required rate of return by invertors is
14% what is market value of debt?

Case 2:

A company has issued irredeemable loan notes with a coupon rate of 7% and
par value of 100. If the required rate of return of investor is 4% what is the
current market value of the debt?

Case 3:

A company issues 9% redeemable debt with 10 years to redemption.

Redemption will be at par. The investors require a return of 16% what is the
market value of the debt?

Case 4:

ABC company issue convertible loan notes with a coupon rate of 12%. Each
$100 loan note may be converted into 20 ordinary shares at any time until the
date of expiry and any remaining loan notes will be redeemed at $100 (Par
value)

The loan notes have five years left to run. Investors would normally require a
rate of return of 8% p.a. on a five-year debt security should investor convert if
current market price is

1. $4.00
2. $5.00
3. $6.00

Case 5:

Suppose ABC Company is planning to obtain listing on stock-exchange by

offering 40% its existing shares to the public. No new share will be issued. Last
statement of comprehensive income is as under

Description Amount
Turn-over 120,000
Earnings 1,500
Number of shares 3,000
The company has 30% debt and 70% equity and it pays regularly pays 50%
dividends and with reinvested earnings is expected to achieve 5% dividend
growth each year summarized balance sheet of a company in the similar
industry and same business as also as under

Description Amount
Capital 50%
Debt 50%
Equity beta 1.5

The current treasury bills yield is 7% a year. The average market return is
estimated to be 12%. The new shares will be issued at discount of 15% to the
estimated post issue price

What will be the issue share price if company has in 30% tax bracket?

Case 6:

You have been provided the following statement of financial position about ABC
Company that can earn $27.5 after tax at constant rate which you want to
acquire and your undiscounted required rate of return is 20%

Assets Amount Liabilities Amoun

t
Sundry net Assets 160 Capital ($10) 50
7% Preference shares 40
Reserves 25
8% Debentures 45
Total 160 Total 160

Debentures and preference shares are to be valued at par. Ignore Taxation

Case 7:

ABC Ltd is contemplating to acquire XYZ Ltd the following information are
provided to you
 Description ABC XYZ
Earnings 100 50
Anticipated growth 4% 2%
Cost of capital 15% 18%

If total earnings of the merged firm will be the sum of current individual
earnings and growth rate will be 5% then what minimum price share holders of
ABC company will accept and what Maximum price share-holders of ABC will
willing to pay? (round off figures to nearest cent)

Solutions

Case 1:

Using P0 = D / Ke = 12 / 0.14 = $85.71

Case 2:

M.V = 7 / 0.04 = $175

Case 3:

Time Cash flow ($) PVIF @16% PV($

1 to 10 9 4.833 43.5
10 100 0.227 22.7
esent value (Current Market value) 66.2

Case 4:

If the security is not converted there will be following benefits to the share-holder

n Amount ($) PVIF @8% P

ayment form (1-5) years 12 3.993 4
on at 5th year 100 0.681 6
ent value 11

Value of equity if security is converted

Number of Market Value of Share Tota

shares
20 4 8
20 5 10
20 6 12
luded that if the market value of the debt raise to 6 then security should be sold as present value of cash that will be received will be 12
$3.980 more than keeping security and break even share market price is 116.02 / 20 = 5.80 per share

Case 5:

As we know that

P0 = [(D0) (1+g) / (Ke-g)]

And for this formula Ke is required which is not provided in the question and for
this first we will convert the beta provided for another company that is geared
and also in the same industry but with different debt/ equity ratio into the beta
of un-geared company the formula is as under

bu = [(bg) / (D/E (1-t))]

bu = [(1.5) / (0.5/0.5 (1-0.3))]
bu = 2.14
Now convert this beta to our current firms capital
structure and as we know that
bu = [(bg) / (D/E (1-t))]
2.14 = [(bg) / (0.3/0.7 (1-0.3))]
bg = 2.4*0.3 = 0.642

According to CAPM model

Ke = rf + b (rm - rf)
Ke = 0.07 + 0.642(0.12-0.07)
Ke = 10.21%

And
P0 = [(D0) (1+g) / (Ke-g)]
P0 = [(0.25) (1+0.05) / (0.1021-0.05)]D0 = EPS * 0.5 =
(1500/3000) = 0.25
P0 = 5.04
And as it is mentioned that shares will be issued at 15% discount so new issue
price will be 5.04(1-0.15) = 4.28

Case 6:

Income before interest 27.50 + (45*0.08) = 31.10

Market value of the firm 31.10 / (0.2) =
155.50

Value of the equity 155.50 – 40 – 45 =

70.50
Value per share 70.50 / 5 = 1.41
Case 7:

Minimum price share holders of XYZ Company will accept

P0 = [(D0) (1+g) / (Ke - g)]

P0 = [(50) (1+0.2) / (0.18 – 0.02)]
P0 = 319

Maximum price share-holders of ABC will willing to pay

As ABC Company will absorb XYZ Company share price of merged firm will
change so share holders ABC Company will calculate the value of the company
before merger and after merger and they will be willing to pay the difference if
there is any gain but after merger cost of capital will also change so first we will
have to calculate that figure. As we know that in the new firm 67% (1000/1500)
shares will be of ABC and remaining 33% (500/1500) will be of XYZ ltd. So new
weighted average cost of capital for merged firm will be

(0.15*0.67) + (0.18*0.33) = 16%

Thus value of new firm

P0 = [(D0) (1+g) / (Ke - g)]

P0 = [(150) (1+0.05) / (0.16 – 0.05)] = 1432
Value of current firm

P0 = [(100) (1+0.04) / (0.15 – 0.04)]

P0 = 946

Total Gain = 1432 – 946 = 486

So the share-holders of ABC will be willing to pay maximum $486 as then there will be loss
on merger

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