Question

Question 2 Mergers and Acquisitions Dynamo Ltd is considering making an offer to purchase Stedrup Ltd. Dynamie's CFO has collected the following information: Dynamo Ltd 18 Stedrup Ltd 12 1,000,000 $1,200,000 $600,000 Price-earnings Ratio Shares outstanding After-tax Earnings Dividends 4,000,000 $4,000,000 $800,000 Dynamo also knows that securities analysts expect the earnings and dividends of Stedrup to grow at a constant rate of 3.5 percent each year. Dynamo Ltd's management believes that the acquisition of Stedrup will provide the firm with some economies of scale that will increase this growth rate to 5 percent per year. Required: a) What is Stedrup Ltd's current cost of equity? (3 marks) What is the value of Stedrup to Dynamo? b) (3 marks) What would Dynamo Ltd's gain be from this acquisition? c) (3 marks) d) If Dynamo were to offer $16 in cash for each share ofStedrup, what would the NPV of the acquisition be? (2 marks) e) What is the most Dynamo should be willing to pay in cash per share for the stock of Stedrup? (2 marks) If Dynamo were to offer 750,000 of its shares in exchange for the outstanding stock of Stedrup, what would the NPV of the proposed merger be? (6 marks) E) Should the acquisition be attempted? If so, which way? (1 mark)

Answer 1

1. PE ratio = share price / earning per share

For Stedrup Ltd,

Here earnings = 1,200,000

No of share = 1,000,000

So earning per share = 1,200,000/1,000,000

= 1.2

And PE ratio = 12

So the price per share = PE ratio * earnings per share

= 12*1.2

= $14.40

Growth of dividend = 3.5%

Dividend per share = 600000/1000000= 0.60

Cost of equity = (DPS/MPS)+g

DPS= Dividend per share. MPS= Market price per share, g= growth rate of dividend

Cost of equity = 0.60/14.40 + 0.035

= 0.04166+0.035

= 0.0766 or 7.67%

2. Value of stredrup to dynamo

Value of stredrup= share price * no. of share= 14.40* 1,000,000= $14,400,000

And value of Dynamo

Here earnings = 4,000,000

No of share = 4,000,000

So earning per share = 4000,000/4,000,000

= 1 -

And PE ratio = 18

So the price per share = PE ratio * earnings per share

= 18*1

= 18

Value of Dynamo = share price * no. of share= 18* 4000000= $72,000,000

Value of stredrup to Dynamo= 14,400,000/72,000,000= 0.20

3. Gain from acquisition will be change in the market price of the shares of Dynamo due to stredrup

Share price after acquisition:

Value of stock = D₁ / (k - g)

where:
D₁ = next year's expected annual dividend per share
k = the investor's discount rate or required rate of return,

g = the expected dividend growth rate (note that this is assumed to be constant)

here growth rate = 5 ( given)

k= 7.67%

D1= Dividend of current year * (1+ growth)

So,

value of stock= 0.60(1+0.05)/(7.67-5.0)%

= 0.60(1.05)/0.026667

= $23.62

So total expected gain = (23.62-14.40 )*1000,000

= $9,2220,000

4. NPV= value of the firm to Dynamo - acquisition cost

Value of firm = 23.62*1000000

Acquisition cost = 16*1000000= 16

NPV= (23.62-16)*1000000= $7,620,000