effects of merger on price and earnings.doc

7/28/2019 Effects of Merger on Price and Earnings.doc

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Effects of Merger on Price and Earnings

Available evidence suggests that target stockholders make significant gains more in

tender offers than in mergers. Andrade, Mitchell, and Stafford found that following

announcement of the bid, selling firm shareholders received a healthy gain averaging 16

percent (1). On the other hand, bidder stockholders earn comparatively little, breaking

even on mergers and making a few percent on tender offers.

Dozens of research studies report that, on average, the wealth of target firm stockholders

is greatly enhanced, while the wealth of acquiring firm stockholders is unaffected, or at

worst, slightly diminished (averaging 4 percent decline).

Announcement Period Abnormal Returns by Decade, 1973-1998

1973-79 1980-89 1990-98 1973-98

Combined

-1 day, +1

day 1.50% 2.60% 1.40% 1.80%-20 day,

Close 0.10% 3.20% 1.60% 1.90%

Target

-1 day, +1

day 16% 16% 15.90% 16%-20 day,

Close 24.80% 23.90% 23.30% 23.80%

Acquirer

-1 day, +1

day -0.30% -0.40% -1.00% -0.70%-20 day,

Close -4.50% -3.10% -3.90% -3.80%

No. Observ. 598 1226 1864 3688

Estimating the Effect of the Merger or Acquisition on Value, EPS, and

Price

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Below is the analysis of merger and its potential effects either favorable or adverse on

price, earnings, and wealth of the stockholders.

In May 2008 Jack Elam, chief executive officers, and Chuck Connors met to discuss the

merger of their companies, Checkers Pizza and Pizza Shack. Table 1 shows the financial

data for both companies before the merger. However, after the merger, they planned to

call the new company, Stop n Go Pizza.

Table-1 Pizza Shack Checkers Pizza

Total Earnings $30,000,000 $15,000,000

Number of Shares 6,000,000 3,000,000

Earnings per Share $5.00 $5.00

Price-to-Earnings Ratio 16 12

Price per Share $80.00 $60.00

Total Value $480,000,000 $180,000,000

Analysis of the Merger and Acquisition and its Effect on Price and EPS

In evaluating the acquisition, the acquiring company must considered the effect the

merger will have on the EPS of the surviving company.

Exchange Ratio and Price Offers

Suppose Pizza Shack considers acquiring Checkers by stock and offers a price of $65

per share. The exchange ratio will be equal to:

sharesBuyerBuyersharesetTetT NPNP = argarg

813.080$

65$arg

arg

===

=

Buyer

etT

sharesetT

sharesBuyers

P

P

N

NER

In total Pizza Shack will issue 2,437,500 shares to acquire Checkers. Assuming that the

earnings of both companies stay the same after acquisition (no synergy), EPS of Stop

n Go will be $5.33, thus, an immediate increase in EPS for Shack ($0.33). However,

there will be a reduction of EPS for Checkers stockholders as they are holding

0.813shares of the Shack Pizza. The post-merger EPS for Checkers stockholders is

equal to: 0.813 ($5.33) =$4.33, compared to $5 per share before the merger.

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Table-2 Pizza Shack Checkers Pizza Stop n Go Pizza

Total Earnings $30,000,000 $15,000,000 $45,000,000

Number of Shares 6,000,000 3,000,000 8,437,500

Earnings per Share $5.00 $5.00 $5.33Price-to-Earnings Ratio 16 12


Total Value $480,000,00

0

$180,000,000

If the price offer was $85 (Shack anxious to acquire Checkers before any other bidders

enter the market), the exchange ratio will be 1.063 shares of Shack for each share of

Checkers. Table-3 shows the result of transaction for both companies.


Total Earnings $30,000,000 $15,000,000 $45,000,000

Number of Shares 6,000,000 3,000,000 9,187,500

Earnings per Share $5.00 $5.00 $4.90



Total Value $480,000,00

0

$180,000,000

In this case, there is dilution for Shacks EPS ($4.90) and a gain of $0.20 per share for

Checkers stockholders ($4.90 x 1.063=$5.30). Dilution in EPS will occur anytime the

P/E ratio paid for a company exceeds the P/E ratio of acquiring company. In the first

scenario the P/E ratio was $65/$5= 15 and in the second scenario were $85/$5 = 17.

Because the P/E of Shack was 16 (above 15) in the first case, there was an increase in

EPS for Shack stockholders and a decline in the second case (P/E offered 17 greater

than 16). The amount of increase or decrease is a function of (1) the differential in P/E

ratios, and (2) the relative size of the two companies as measured by their total earnings.

The higher the P/E ratio and the larger the earnings of acquiring company, the greater

the increase in EPS of acquiring company relative to the target company and vice versa.

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Exchange Ratio Based on EPS

If the merger takes place on the basis of EPS and assuming no growth in the post-

merger then, there will not be any earnings dilution as shown in table 4. It is clear that

the equivalent earnings per share after the merger are the same as before the merger.The effect on market values, however, will depend on the size of the P/E ratio that

prevails.

Table-4 shows the effect of exchange ratio of 1,

15$

5$arg===

Buyer

etT

EPS

EPSER

Under this scenario, both companies are about as well off as before.


Total Earnings $30,000,000 $15,000,000 $45,000,000

Number of Shares 6,000,000 3,000,000 9,000,000




Total Value $480,000,000 $180,000,000

Market Price Based Perceived P/E Ratio

If the decision to acquire another company were based solely upon the initial impact on

EPS and its dilution, no company would have engaged in merger and acquisition.

Until now we have ignored the effect of synergy and value creation of the combined

companies. For example, if the combined company was able reduce its costs with

efficiencies and to increase its revenue by 10%, and then a higher price and P/E ratio

may be justified.

The effects on market price are less than certain. If the combined company sells at

Checker Pizzas price-earnings ratio of 12, the market value per share of the new

company will be $70.40 and with post-merger EPS of $4.77. The post-merger price for

both stockholders will be equal to: Post- Merger Price= 0.813*($70.40) = $57.20.

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If , on the hand, the earnings of the Stop n Go are valued at Pizza Shacks price-

earnings ratio of 16, the market value per share of the new company will be $93.87

(Table 5). In this case, shareholders of both companies will have benefited.

Table-5 Pizza Shack Checkers Pizza Stop n Go Pizza Stop n Go Pizza

Total Earnings $30,000,000 $15,000,000 $49,500,000 $49,500,000

Number of Shares 6,000,000 3,000,000 8,437,500 8,437,500

Earnings per Share $5.00 $5.00 $5.87 $5.87

Price-to-Earnings Ratio 16 12 12 16

Price per Share $80.00 $60.00 $70.40 $93.87

Total Value $480,000,000 $180,000,000 $594,000,000 $792,000,000

Table-6 shows the price and gradual price gains at different P/E ratio.

Table-6 Stop n Go Pizza Stop n Go Pizza Stop n Go Pizza

Total Earnings $49,500,000 $49,500,000 $49,500,000

Number of Shares 8,437,500 8,437,500 8,437,500


Price-to-Earnings

Ratio

13 14 15

Price per Share $76.27 $82.13 $88.00

Total Value $643,500,000 $693,000,000 $742,500,000

Post-Merger Price for

Checkers Shareholders $61.97 $66.73 $71.50

The above example shows that the acquiring company must consider the possibility that

its P/E ratio will change depending how the market sees the benefit of the merger. If the

market does not recognize any synergy from the merger, then we would expect the

price-earnings ratios of the new combined company will approach a weighted average

of the two price P/E ratios. Under this condition acquisition of companies with lower

P/E ratio would not enhance shareholder wealth.

In fact if the price offer was more than $80, let say $85 per share, then there is a transfer

of wealth from the stockholders of acquiring company to those companies that are being

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acquired. Table-7 shows the exchange ratio of 1.063 ($85/$85) and the benefits of

higher price to Checkers shareholders.

Table-7 Stop n Go Pizza Stop n Go Pizza Stop n Go Pizza

Total Earnings $49,500,000 $49,500,000 $49,500,000

Number of Shares 9,187,500 9,187,500 9,187,500


Price-to-Earnings Ratio 13 14 15

Price per Share $70.04 $75.43 $80.82

Total Value $643,500,000 $693,000,000 $742,500,000

Post-Merger Price for

Checkers Shareholders $74.42 $80.14 $85.87

Part II

Suppose Checkers Pizza has the following projected cash flows and demands a 30%

premium to merger with Pizza Shack.

Year(s) Cash Flows

1 $15,000,000

2 17,000,000

3 20,000,000

4 21.500,000

5 22,000,000

Checkers Pizza expects a terminal (constant) growth rate of 6% after five years.

What is the value of the company if the risk-free rate is 4%, the required return on the

market is 12%, and the beta of the firm is 1.0?

Determine the maximum price Pizza Shack can afford to pay

If Checker's current equity value is $180,000,000 will the merger take place?

The discount rate R =4% + 1(12% 4%) = 12%

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Value

Year(s) CF

PV (Cash

Flows)

1 $15,000,000 $13,392,857

2 $17,000,000 $13,552,2963 $20,000,000 $14,235,605

4 $21,500,000 $13,663,639

5 $22,000,000 $12,483,391

Terminal Cash Flow (@

6%) $23,100,000

PV(Terminal Value) $187,250,862

Value $254,578,650

Total discounted present value of all future cash flows at 12% = $254,578,650.Therefore, the net present value of the expected future cash flows exceeds excepted

value adjusted for 30% premium ( $254,578,650- $234,000,000)= $20, 578,650. So the

price offer should be less than 85 per share since at $85 price per share there was a

transfer of wealth to Checkers shareholders.

Expected value of not tendering (EVNT)

The task of participants in a takeover is to anticipate the thinking of arbitrageurs and

leading investors as the bidding proceeds. Once the player knows the logic of investors,

one can use it to chart a course through the bidding.

To understand how the market prices the target, consider two scenarios:

Scenario 1: targets value is less than tender offer:

If, subsequent to the tender offer, the market price of the target remains below the

tender-offer value, this price (say, $62.00) reflects some uncertainty regarding the

success of the merger.

If Checkers tender offer is $ 65, then, based on the following assumptions:

1. In the short run, Checkers management will be unable to increase the $60 per-share

value.

2. There is no competitive bidder who is interested in Checkers at a price greater than

$65 per share.

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3. Time value of money is ignored.

Checkers market price = (a PO) + (c PT) = $ 62

a= Probability that offer will not succeed p

PO = Original market price of the target company $60

c= Probability that offer will succeed 1 - p

PT = Shacks tender offer $ 65

(P $60) + (1-P) $65 = $62 p=60%

Thus, p, the probability that the offer will not succeed, equals 60 percent. One would

conclude that the market believes the offer will not succeed.

Scenario 2: targets value is more than tender offer:

If, subsequent to the tender offer, the market price of the target ($70) exceeds the tender

value and investors believe that a competing bidder or the existing management will

eventually offer $75:

If Pizza Shacks tender offer is $ 65, then, based on the following assumptions:

1. In the short run, Checkers management will be unable to increase the $70 per-share

value.2. There is a competitive bidder who is interested in Checkers at $75 in the near future.

3. Time value of money is ignored.

Checkers market price = (a b) + (c d) = $ 60

a= Probability that no competitive bid will made P

b= Original market price of the target company $ 60

c= Probability that competitive bid will be made 1-P

d. Competitive tender offer $ 75

(P $60) + (1-P) $75 = $70 p=33.33%

When we solve for the probability that a competitive bid will be made, 1- P equals 67%

percent. The example suggests that the higher the share price in response to bid price,

the greater the expected value of a competing bid and the probability that a competitor

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will offer a bid. Once we have understood the probabilistic logic of investors, Checker

Pizza can extend it and game it to its advantage. Under Scenario 1, Checker Pizza

cannot do anything more than satisfy regulators regarding compliance with all legal

requirements and investors regarding the strategic fit of this merger. If there are no

competitors interested in bidding for Checker Pizza at a price higher than the initial bid

of $65.00, no upward revision in bid is required. But if competitors are expected, then

Scenario 2 becomes relevant.

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