When a firm has cash flow problems, there are potential negative feedback effects. For example, the firm may need to cut capital expenditures and research and development activities that are necessary to remain competitive in its industry.
Your firm, Goldmine Incorporated, is considering the purchase of a technology firm called Techworks. The reason that your firm is considering this purchase is that when Goldmine has a bad year, Techworks tends to have a good year. Thus, Goldmine will not have cash flow problems in its bad years because Techworks would produce high cash flows in those years.
Specifically, one of three states can occur every year (in perpetuity). Here are the cash flows produced by each firm within each state:
In addition, assume that the Goldmine cash flow in State A will be $30M lower because of the negative feedback effects resulting from the cash flow problems. If Goldmine purchases Techworks, then Goldmine will not incur this $30M cost in State A.
Assume that the annual expected return on Goldmine assets is 8 percent and the expected return on Techworks assets is 10 percent. Both firms are all-equity and will operate in perpetuity. Each firm has 20M shares outstanding.
a) First assume that no merger announcement has been made yet. What is the price per share of each firm?
Goldmine announces that it will purchase all of the shares in Techworks and pay a premium of 20 percent on the Techworks share price that you calculated in part (a). This will be a stock-for-stock merger. That is, Goldmine will issue shares in its own firm and exchange them for shares in Techworks (the exchange will be based on the value of Goldcorp shares from (a) relative to the value of Techworks shares with the 20 percent premium).
b) What percentage of Goldcorp will have to be sold in order to acquire all of the shares in Techworks?
c) What is the value of the combined firm?
d) Is the merger a good idea? For this, you will have to compare the value created from the merger to its cost.
e) What is the share price of Goldcorp after it purchases Techworks? Compare this to the price per share calculated for Goldcorp in part (a).