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Both of these firms are 100 percent equity. You estimate that the incremental value of the acquisition, AV, is $100.

The board of Firm B has indicated that it will agree to a sale if the price is $150, payable in cash or stock. This price for Firm B has two parts. Firm B is worth $100 as a standalone, so this is the minimum value that we could assign to Firm B. The second part, $50, is called the merger premium, and it represents the amount paid above the stand-alone value.

Should Firm A acquire Firm B? Should it pay in cash or stock? To answer, we need to determine the NPV of the acquisition under both alternatives. We can start by noting that the value of Firm B to Firm A is:

The total value received by A as a result of buying Firm B is thus $200. The question then is, How much does Firm A have to give up? The answer depends on whether cash or stock is used as the means of payment.

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