Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VIII. Topics in Corporate

Finance

25. Mergers and
    Acquisitions

© The McGraw−Hill^879

Companies, 2002

EPS Growth

An acquisition can create the appearance of growth in earnings per share, or EPS. This
may fool investors into thinking that the firm is doing better than it really is. What hap-
pens is easiest to see with an example.
Suppose Global Resources, Ltd., acquires Regional Enterprises. The financial posi-
tions of Global and Regional before the acquisition are shown in Table 25.3. We assume
that the merger creates no additional value, so the combined firm (Global Resources af-
ter acquiring Regional) has a value that is equal to the sum of the values of the two firms
before the merger.
Before the merger, both Global and Regional have 100 shares outstanding. However,
Global sells for $25 per share, versus a price of $10 per sharefor Regional. Global
therefore acquires Regional by exchanging 1 of its shares for every 2.5 Regional shares.
Because there are 100 shares in Regional, this will take 100/2.5 40 shares in all.
After the merger, Global will have 140 shares outstanding, and several things will
happen (see the third column of Table 25.3):

1. The market value of the combined firm is $3,500. This is equal to the sum of the
   values of the separate firms before the merger. If the market is “smart,” it will
   realize that the combined firm is worth the sum of the values of the separate firms.


2. The earnings per share of the merged firm are $1.43. The acquisition enables Global
   to increase its earnings per share from $1 to $1.43, an increase of 43 percent.


3. Because the stock price of Global after the merger is the same as that before the
   merger, the price-earnings ratio must fall. This is true as long as the market is smart
   and recognizes that the total market value has not been altered by the merger.
   If the market is “fooled,” it might mistake the 43 percent increase in earnings per
   share for true growth. In this case, the price-earnings ratio of Global may not fall after
   the merger. Suppose the price-earnings ratio of Global remains equal to 25. Because the
   combined firm has earnings of $200, the total value of the combined firm will increase
   to $5,000 (25  $200). The per-share value for Global will increase to $35.71
   ($5,000/140).
   This is earnings growth magic. Like all good magic, it is just illusion. For it to work,
   the shareholders of Global and Regional must receive something for nothing. This, of
   course, is unlikely with so simple a trick.

CHAPTER 25 Mergers and Acquisitions 855

TABLE 25.3

Financial Positions of

Global Resources and

Regional Enterprises

Global Resources

after Merger

Global Regional

Resources Enterprises The Market The Market

before Merger before Merger Is Smart Is Fooled

Earnings per share $1 $1 $1.43 $1.43

Price per share $25 $10 $25 $35.71

Price-earnings ratio 25 10 17.5 25

Number of shares 100 100 140 140

Total earnings $100 $100 $200 $200

Total value $2,500 $1,000 $3,500 $5,000

Exchange ratio: 1 share in Global for 2.5 shares in Regional.