Which of the following is true if no synergies occur after the merger of two firms?
Answer (D) is correct. Diversification is sometimes claimed to be an advantage of a combination because it stabilizes earnings and reduces the risks to employees and creditors. Thus, the coinsurance effect applies. If one of the combining firms fails, creditors can be paid from the assets of the other. However, whether shareholders benefit is unclear. One argument supporting the view that diversification by itself does not benefit shareholders is that the decrease in earnings variability increases the value of debt
at the expense of equity. Absent synergy, the value of the combined firm is the same as the total of the values of the separate firms. Because the debt increases in value as a result of the decreased risk of default (the coinsurance effect), the value of the equity must therefore decrease if the total value of debt and equity is unchanged.
The coinsurance effect can be reduced by
Retirement of Debt before a Combination
Issuance of Debt after a Combination
Answer (A) is correct. The coinsurance effect can be offset by issuing additional debt after the combination, thereby increasing the firmís unsystematic risk and decreasing the value of debt. Moreover, the greater leverage may increase the firmís value. Another possibility is to reduce debt prior to the combination at the lower, pre-combination price and then to reissue the same amount of debt afterward.
Ogden Enterprises is a holding company for several successful retail businesses including bookstores, pharmacies, and gourmet food shops. Ogden has excess cash and long-range plans to acquire businesses outside the retail industry. The company is currently considering the acquisition of G-Tech Inc., a company involved in the research and development of genetically engineered pharmaceuticals. G-Tech was founded 4 years ago and received its initial financing from a venture capital group. G-Tech recently submitted its first product to the Food and Drug Administration for testing and is readying a second product for submission; however, it will be several years before either of these products can be marketed. The venture capital group would like to sell the company but does not believe a public offering would do well. G-Tech is in need of cash and close monitoring to improve its operational efficiency. G-Tech is most likely to be an attractive investment to Ogden because of
Answer (B) is correct.
Financial synergy may result from the combination. The cost of capital for both firms may be decreased because the cost of issuing both debt and equity securities is lower for larger firms. Moreover, uncorrelated cash flow streams will provide for increased liquidity and a lower probability of bankruptcy. Still another benefit is the availability of additional internal capital. The acquired company is often able to exploit new investment opportunities because the acquiring company has excess cash flows. The strategic position of the combined firm also will be improved because G-Tech provides a beachhead in the field of genetically engineered pharmaceuticals. Finally, G-Tech is a development stage enterprise that most likely has a net operating loss carryforward that Ogden, a successful conglomerate, can use to reduce its tax liability.
After a merger, the difference between the value of the combined entity and the sum of the values of the separate entities is
Answer (D) is correct. Operational synergy arises because the combined firm may be able to increase its revenues and reduce its costs. For example, the new firm created by a horizontal merger may have a more balanced product line and a stronger distribution system. Furthermore, costs may be decreased because of economies of scale in production, marketing, purchasing, and management. Financial synergy may also result from the combination. The cost of capital for both firms may be decreased because the cost of issuing both debt and equity securities is lower for larger firms. Moreover, uncorrelated cash flow streams will provide for increased liquidity and a lower probability of bankruptcy. Still another benefit is the availability of additional internal capital. The acquired company is often able to exploit new investment opportunities because the acquiring company has excess cash flows.
Which of the following is most likely to be a bad reason for a business combination involving publicly held companies?
Answer (A) is correct. Unsystematic risk is unique to the firm and can be diversified in a combination, but shareholders can diversify simply by purchasing shares in a variety of firms. Diversification by individual shareholders is therefore easier and cheaper than by the firm except in the case of closely held firms.
The synergy of a business combination can be determined by
Answer (C) is correct. Synergy equals the value of the combined firm minus the sum of the values of the separate firms. These values can be calculated using the capital budgeting technique of discounted cash flow analysis. The difference between the cash flows of the combined firm and the sum of the cash flows of the separate firms is discounted at the appropriate rate, usually the cost of equity of the acquired firm. The components of the incremental cash flows are the incremental revenues, costs, taxes, and capital needs.
Which of the following is not a revenue enhancement advantage of acquiring another firm?
Answer (D) is correct. Economies of scale in production, marketing, purchasing, management, etc., arise
from decreasing unit cost resulting from higher levels of activity. Thus, economies of scale produce synergy in the form of cost reduction rather than revenue enhancement.
A company transferred ownership of one of its divisions to the companyís existing shareholders, and the shareholders received new stock representing separate ownership rights in the division. That process is referred to as a
Answer (B) is correct. A spin-off is a type of restructuring that is characterized by establishing a new and separate entity and transferring its newly issued stock to the shareholders of the original company.
Which of the following defense maneuvers involves the issuance of rights to buy shares at an extremely reduced price upon the occurrence of a takeover?
Answer (C) is correct. A poison pill may be included in a target corporationís charter, by-laws, or contracts to reduce its value to potential tender offerors. A poison pill may be, for example, a right granted to the target firmís shareholders to purchase shares of the merged firm resulting from a takeover. The bidding company loses money on its shares because this right dilutes the value of its stock.
A large U.S. company recently set up a new corporation based on the assets from one of its divisions. The stock of the new corporation was titled to the stockholders of the original firm. This change is an example of a
Answer (D) is correct. The transaction described is a spin-off, which is a kind of divestiture. The types of divestiture are sale of a subunit to another company, sale of a subunit to the subunitís management, piecemeal liquidation of the subunitís assets, and a spin-off. This last form of divestiture is characterized by establishing a new and separate entity and transferring its newly issued stock to the shareholders of the original company.