Table 253

Financial Positions of Global Resources and Regional Enterprises

Exchange ratio: 1 share in Global for 2.5 shares in Regional.

EPS Growth

An acquisition can create the appearance of growth in earnings per share, or EPS. This may fool investors into thinking that the firm is doing better than it really is. What happens is easiest to see with an example.

Suppose Global Resources, Ltd., acquires Regional Enterprises. The financial positions of Global and Regional before the acquisition are shown in Table 25.3. We assume that the merger creates no additional value, so the combined firm (Global Resources after acquiring Regional) has a value that is equal to the sum of the values of the two firms before the merger.

Before the merger, both Global and Regional have 100 shares outstanding. However, Global sells for $25 per share, versus a price of $10 per share for Regional. Global therefore acquires Regional by exchanging 1 of its shares for every 2.5 Regional shares. Because there are 100 shares in Regional, this will take 100/2.5 = 40 shares in all.

After the merger, Global will have 140 shares outstanding, and several things will happen (see the third column of Table 25.3):

1. The market value of the combined firm is $3,500. This is equal to the sum of the values of the separate firms before the merger. If the market is "smart," it will realize that the combined firm is worth the sum of the values of the separate firms.

2. The earnings per share of the merged firm are $1.43. The acquisition enables Global to increase its earnings per share from $1 to $1.43, an increase of 43 percent.

3. Because the stock price of Global after the merger is the same as that before the merger, the price-earnings ratio must fall. This is true as long as the market is smart and recognizes that the total market value has not been altered by the merger.

If the market is "fooled," it might mistake the 43 percent increase in earnings per share for true growth. In this case, the price-earnings ratio of Global may not fall after the merger. Suppose the price-earnings ratio of Global remains equal to 25. Because the combined firm has earnings of $200, the total value of the combined firm will increase to $5,000 (25 X $200). The per-share value for Global will increase to $35.71 ($5,000/140).

This is earnings growth magic. Like all good magic, it is just illusion. For it to work, the shareholders of Global and Regional must receive something for nothing. This, of course, is unlikely with so simple a trick.

Ross et al.: Fundamentals I VIII. Topics in Corporate I 25. Mergers and I I © The McGraw-Hill of Corporate Finance, Sixth Finance Acquisitions Companies, 2002

Edition, Alternate Edition

856 PART EIGHT Topics in Corporate Finance

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