1) Acquisition Analysis -mergers and acquisitions

Your company has earnings per share of $4. It has 1 million shares outstanding, each of which has a price of $40. You are thinking of buying Target Co, which has earnings per share of $2, 1 million shares outstanding, and a price per share of $25. You will pay for Target Co by issuing new shares. There are no expected synergies from the transaction.

a. If you pay no premium to buy Target Co, what will your earnings per share be after the merger?

b. Suppose you offer an exchange ratio such that, at current preannouncement share prices for both firms, the offer represents a 20% premium to buy TargetCo. What will your earnings per share be after the merger?

c. What explains the change in earnings per share in part (a)? Are your shareholders any better or worse off? 

d. What will your price-earnings ratio be after the merger (if you pay no premium)? How does this compare to your P/E ratio before the merger? How does this compare to Target Co’s premerger P/E ratio?

2) Managerial Decision based on Financial Distress, Managerial Incentives and Information

As in Problem 1, Gladstone Corporation is about to launch a new product. Depending on the success of the new product, Gladstone may have one of four values next year: $150 million, $135 million, $95 million, or $80 million. These outcomes are all equally likely, and this risk is diversifiable. Suppose the risk-free interest rate is 5% and that, in the event of default, 25% of the value of Gladstone’s assets will be lost to bankruptcy costs. (Ignore all other market imperfections, such as taxes.)
a. What is the initial value of Gladstone’s equity without leverage?

Now suppose Gladstone has zero-coupon debt with a $100 million face value due next year. 

b. What is the initial value of Gladstone’s debt?
c. What is the yield-to-maturity of the debt? What is its expected return?
d. What is the initial value of Gladstone’s equity? What is Gladstone’s total value with leverage?

Suppose Gladstone has 10 million shares outstanding and no debt at the start of the year.

e. If Gladstone does not issue debt, what is its share price?

f. If Gladstone issues debt of $100 million due next year and uses the proceeds to repurchase shares, what will its share price be? Why does your answer differ from that in part (e)? 

3) Financial Distress, Managerial Incentives, and Information 

Kohwe Corporation plans to issue equity to raise $50 million to finance a new investment. After making the investment, Kohwe expects to earn free cash flows of $10 million each year. Kohwe currently has 5 million shares outstanding, and it has no other assets or opportunities.
Suppose the appropriate discount rate for Kohwe’s future free cash flows is 8%, and the only capital market imperfections are corporate taxes and financial distress costs.
a. What is the NPV of Kohwe’s investment?

b. What is Kohwe’s share price today?

Suppose Kohwe borrows the $50 million instead. The firm will pay interest only on this loan each year, and it will maintain an outstanding balance of $50 million on the loan. Suppose that Kohwe’s corporate tax rate is 40%, and expected free cash flows are still $10 million each year. 

c. What is Kohwe’s share price today if the investment is financed with debt?

Now suppose that with leverage, Kohwe’s expected free cash flows will decline to $9 million per year due to reduced sales and other financial distress costs. Assume that the appropriate discount rate for Kohwe’s future free cash flows is still 8%. 

d. What is Kohwe’s share price today given the financial distress costs of leverage?