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^881

Companies, 2002

Both of these firms are 100 percent equity. You estimate that the incremental value of
the acquisition, V, is $100.
The board of Firm B has indicated that it will agree to a sale if the price is $150,
payable in cash or stock. This price for Firm B has two parts. Firm B is worth $100 as a
standalone, so this is the minimum value that we could assign to Firm B. The second
part, $50, is called the merger premium, and it represents the amount paid above the
stand-alone value.
Should Firm A acquire Firm B? Should it pay in cash or stock? To answer, we need
to determine the NPV of the acquisition under both alternatives. We can start by noting
that the value of Firm B to Firm A is:

VB*VVB

$100  100 $200

The total value received by A as a result of buying Firm B is thus $200. The question
then is, How much does Firm A have to give up? The answer depends on whether cash
or stock is used as the means of payment.

Case I: Cash Acquisition

The cost of an acquisition when cash is used is just the cash itself. So, if Firm A pays
$150 in cash to purchase all of the shares of Firm B, the cost of acquiring Firm B is
$150. The NPV of a cash acquisition is:

NPVVB*
Cost

$200 
 150 $50

The acquisition is therefore profitable.
After the merger, Firm AB will still have 25 shares outstanding. The value of Firm A
after the merger is:

VABVA(VB*
Cost)

$500  200 
 150

 $550

This is just the premerger value of $500 plus the $50 NPV. The price per share after the
merger is $550/25 $22, representing a gain of $2 per share.

Case II: Stock Acquisition

Things are somewhat more complicated when stock is the means of payment. In a cash
merger, the shareholders in B receive cash for their stock, and, as in the U.S.
Steel–Marathon Oil example, they no longer participate in the company. Thus, as we
have seen, the cost of the acquisition in this case is the amount of cash needed to pay off
B’s stockholders.
In a stock merger, no cash actually changes hands. Instead, the shareholders of
Firm B come in as new shareholders in the merged firm. The value of the merged firm
in this case will be equal to the premerger values of Firms A and B plus the incremental
gain from the merger, V:

VABVAVBV

$500  100  100

$700

CHAPTER 25 Mergers and Acquisitions 857