Acquirer Company is considering buying Target Company. The current value of equity of Acquirer is $60 million and that of Target is $30 million. Both companies have 1 million shares outstanding. The current beta of equity of Acquirer is 0.8 and that of Target is 1. Acquirer and Target have no debt. After the merger there will be no change in debt structure.
After the merger Target’s cash flows will remain unchanged, while that of the Acquirer will increase due to some synergies. The post-tax cash flow form synergies is estimated to be $1 million in the first year, and expected to grow at 1% per year, forever. These will have the same risk as rest of the Acquirer’s cash flows.
The tax rate for both Acquirer and Target is 25%. Assume depreciation will be zero for both companies for all years. The risk-free rate is 4% and the market risk premium is 6%.
a) The managers of Target are willing to sell the company for $45 million in cash. What is the gain/loss to Acquirer’s shareholders if they accept this offer? Should they accept this offer?
b) What is the maximum that Acquirer should be willing to pay for Target in a cash offer? (Hint: That is when the current shareholders of Acquirer just ‘break even”)
c) Suppose Acquirer wants to undertake the merger using its own stock and not pay cash. The managers of Acquirer think that a cash offer of $40 million is reasonable for buying Target. They want to know what the equivalent offer in terms of stock should be. How many new shares should be issued and offered by Acquirer in exchange for all the shares of Target to undertake the merger? Support your argument with detailed calculations?