Solution to FE2006, Question 7 on Merger & Acquisition

(a)

Sirius :

20 million shares @ 10/share

If bid is successful
# of shares owned =
=
Worth of shares
=
=

20 million x 51%
10.2 million
10.2 million x 15
153 million

Cost of acquisition
First 5%
purchased from open market
=
5% (20 million) (10)
=
10 million
Remaining 46% from existing shareholders
=
46% (20 million) (15)
=
138 million
Total cost
= 10 + 138 million + 7.5 million
= 155.5 million
Cost of acquisition is more than the worth of shares not a profitable
bid

Copyright Impact Consultancy & Training Pte Ltd

(b)

(i)

Gain from acquisition

=
=

6 million - 3 million
3 million

(ii)

Net Gain to shareholders of Firm A

= 6 million - (500,000 x 8)
= 6 million - 4 million = 2 million

(iii)

# of New shares to be issued

= 500,000 = 250,000 shares
2
Equity in Firm A belonging to As shareholders
= (20 million + 6 million) x 1,000,000
1,250,000
= 20.8 million
Net Gain from acquisition
= 20.8 million - 20 million = 0.8 million

(iv)

Bidders may offer stock they believe that their firm is overvalued.

Copyright Impact Consultancy & Training Pte Ltd

(c)

Free rider problem in take over bid demonstrated by Grossman & Hart
(1980) model lead to the result of impossibility of efficient takeover.
Assumptions :
1) Existence of a takeover bid from an external raider
2) Raider must gain at least 50% of shares
3) Firm value will increase by z from y if bid succeeds, and this is a
common knowledge
4) Target firm has a set of homogeneous shareholders
5) Raider offers a premium of over and above the current firm value
to purchase the outstanding shares and also incurs administrative
takeover cost of c.
For takeover to be efficient :

z c

From raiders perspective, profitable takeover :

z >p+c

Given increase in firm value is a common knowledge :

p > z

Therefore, the condition required :

For raider : z > p + c
For shareholders : p > z
The above two parameters contradict each other. Hence an efficient
takeover will not materialize.
However, if minority shareholders bargaining power can be diluted,
i.e. the raider threatens to exact of firm value (by paying himself an
astronomical salary, selling the firms output to another corporation
he owns at a knockdown price etc.)
The premium demanded by shareholders will be modified as :
P> z-
Hence, a profitable takeover is possible when
z > (p + c)
z > (z - + c)
>c
Alternatively, if the raider is able to secretly accumulate block of shares
in the target company, and will make a gain on their holding when
takeover goes ahead. This could also alleviate free riding problem and
allow for efficient takeover gain.

Copyright Impact Consultancy & Training Pte Ltd