Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Option Valuation © The McGraw−Hill^855
Companies, 2002
If you do check these, you may get slightly different answers if you use Table 24.3 (we
used an options calculator).
After the merger, the combined firm’s assets will simply be the sum of the premerger
values, $30 $10 $40, because no value was created or destroyed. Similarly, the to-
tal face value of the debt is now $16 million. However, we will assume that the com-
bined firm’s asset return standard deviation is 40 percent. This is lower than for either
of the two individual firms because of the diversification effect.
So, what is the impact of this merger? To find out, we compute the postmerger value
of the equity. Based on our discussion, here is the relevant information:Once again, we can calculate equity and debt values:What we notice is that this merger is a terrible idea, at least for the stockholders! Before
the merger, the stock in the two separate firms was worth a total of $20.394 6.992
$27.386 million compared to only $26.602 million postmerger, so the merger vaporized
$27.386 26.602 $.784 million, or almost $1 million, in equity.
Where did $1 million in equity go? It went to the bondholders. Their bonds were
worth $9.606 3.008 $12.614 million before the merger and $13.398 million after,
a gain of exactly $.784 million. Thus, this merger neither created nor destroyed value,
but it shifted it from the stockholders to the bondholders.
Our example shows that pure financial mergers are a bad idea, and it also shows why.
The diversification works in the sense that it reduces the volatility of the firm’s return on
assets. This risk reduction benefits the bondholders by making default less likely. This is
sometimes called the “co-insurance” effect. Essentially, by merging, the firms insure each
other’s bonds. The bonds are thus less risky, and they rise in value. If the bonds increase
in value, and there is no net increase in asset values, then the equity must decrease in
value. Thus, pure financial mergers are good for creditors, but not stockholders.
Another way to see this is that since the equity is a call option, a reduction in return
variance on the underlying asset has to reduce its value. The reduction in value in the
case of a purely financial merger has an interesting interpretation. The merger makes de-
fault (and, thus, bankruptcy) lesslikely to happen. That is obviously a good thing from
a bondholder’s perspective, but why is it a bad thing from a stockholder’s perspective?
The answer is simple: The right to go bankrupt is a valuable stockholder option. A
purely financial merger reduces the value of that option.Combined Firm
Market value of equity $26.602 million
Market value of debt $13.398 millionCombined Firm
Market value of assets $40 million
Face value of pure discount debt $16 million
Debt maturity 3 years
Asset return standard deviation 40 percentSunshine Swimwear Polar Winterwear
Market value of equity $20.394 million $6.992 million
Market value of debt $ 9.606 million $3.008 million830 PART EIGHT Topics in Corporate Finance