The postmerger earnings per share for owners of the

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Unformatted text preview: e to pay less than its current value per dollar of earnings to acquire each dollar of earnings (P/E paid P/E of acquiring company), the opposite effects would result. The postmerger earnings per share for owners of the acquiring and target companies can be explained by comparing the price/earnings ratio paid by the acquiring company with its initial P/E ratio. This relationship is summarized in Table 17.6. By paying more than its current value per dollar of earnings to acquire each dollar of earnings (P/E paid P/E of acquiring company), the acquiring firm transfers the claim on a portion of its premerger earnings to the owners of the target firm. Therefore, on a postmerger basis the target firm’s EPS increases, and the acquiring firm’s EPS decreases. Note that this outcome is nearly always the case, because the acquirer typically pays, on average, a 50 percent premium above the target firm’s market price, which results in the P/E paid being much above its own TABLE 17.5 Summary of the Effects on Earnings Per Share of a Merger Between Grand Company and Small Company at $110 Per Share Earnings per share Stockholders Before merger After merger Grand Company $4.00 $3.93a Small Company 5.00 5.40b a $500,000 $100,000 125,000 (1.375 20,000) b$3.93 1.375 $5.40 $3.93 726 PART 6 Special Topics in Managerial Finance TABLE 17.6 Effect of Price/Earnings (P/E) Ratios on Earnings Per Share (EPS) Effect on EPS Relationship between P/E paid and P/E of acquiring company Acquiring company Target company P/E paid P/E of acquiring company Decrease Increase P/E paid P/E of acquiring company Constant Constant P/E paid P/E of acquiring company Increase Decrease P/E. The P/E ratios associated with the Grand–Small merger demonstrate the effect of the merger on EPS. EXAMPLE Grand Company’s P/E ratio is 20, and the P/E ratio paid for Small Company’s earnings was 22 ($110 $5). Because the P/E paid for Small Company was greater than the P/E for Grand Company (22 versus 20), the effect of the merger was to decrease the EPS for original holders of shares in Grand Company (from $4.00 to $3.93) and to increase the effective EPS of original holders of shares in Small Company (from $5.00 to $5.40). Long-Run Effect The long-run effect of a merger on the earnings per share of the merged company depends largely on whether the earnings of the merged firm grow. Often, although an initial decrease in the per-share earnings of the stock held by the original owners of the acquiring firm is expected, the long-run effects of the merger on earnings per share are quite favorable. Because firms generally expect growth in earnings, the key factor enabling the acquiring company to experience higher future EPS than it would have without the merger is that the earnings attributable to the target company’s assets grow more rapidly than those resulting from the acquiring company’s premerger assets. An example will clarify this point. EXAMPLE In 2003, Grand Company acquired Small Company by swapping 1.375 shares of it...
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This document was uploaded on 01/19/2014.

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