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Unformatted text preview: , it is useful to consider the
effects of a proposed merger on earnings per share—the accounting returns that
are related to cash flows and value (see Chapter 7). Ordinarily, the resulting earnings per share differ from the premerger earnings per share for both the acquiring
firm and the target firm. They depend largely on the ratio of exchange and the
premerger earnings per share of each firm. It is best to view the initial and longrun effects of the ratio of exchange on earnings per share separately.
Initial Effect When the ratio of exchange is equal to 1 and both the acquiring firm and the target firm have the same premerger earnings per share, the
merged firm’s earnings per share will initially remain constant. In this rare
instance, both the acquiring firm and the target firm would also have equal
price/earnings (P/E) ratios. In actuality, the earnings per share of the merged firm
are generally above the premerger earnings per share of one firm and below the
premerger earnings per share of the other, after the necessary adjustment has
been made for the ratio of exchange.
EXAMPLE As we saw in the preceding example, Grand Company is contemplating acquiring
Small Company by swapping 1.375 shares of its stock for each share of Small’s
stock. The current financial data related to the earnings and market price for each
of these companies are given in Table 17.4.
To complete the merger and retire the 20,000 shares of Small Company stock
outstanding, Grand will have to issue and (or) use treasury stock totaling 27,500
shares (1.375 20,000 shares). Once the merger is completed, Grand will have
152,500 shares of common stock (125,000 27,500) outstanding. If the earnings
of each of the firms remain constant, the merged company will be expected to
have earnings available for the common stockholders of $600,000 ($500,000
$100,000). The earnings per share of the merged company therefore should equal
approximately $3.93 ($600,000 152,500 shares). CHAPTER 17 TABLE 17.4 725 Mergers, LBOs, Divestitures, and Business Failure Grand Company’s and Small Company’s
Financial Data Item Grand Company Small Company $500,000 $100,000 125,000 20,000 (1) Earnings available for common stock
(2) Number of shares of common stock outstanding
(3) Earnings per share [(1) (2)] $4 (5) Price/earnings (P/E) ratio [(4) $75 20 (3)] $5 $80 (4) Market price per share 15 It would appear at first that Small Company’s shareholders have sustained a
decrease in per-share earnings from $5 to $3.93, but because each share of Small
Company’s original stock is equivalent to 1.375 shares of the merged company’s
stock, the equivalent earnings per share are actually $5.40 ($3.93 1.375). In
other words, as a result of the merger, Grand Company’s original shareholders
experience a decrease in earnings per share from $4 to $3.93 to the benefit of
Small Company’s shareholders, whose earnings per share increase from $5 to
$5.40. These results are summarized in Table 17.5.
Hint If the acquiring
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