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its overall cost of capital will be 14 percent because Masters Corporation is financed mostly with equity. The
acquisition is anticipated to generate yearly cash inflows of $28,000 for the next 10 years.
The net present value is:
Calculations Present Value
$200,000
$200,000 x 1
Year 0
+146,048
Years 110 +$28,000 X 5.216
Net present value $ 53,952
Since the net present value is negative, the acquisition should not take place.
Acquisition of Assets for Cash
When one company acquires .another for cash, capital budgeting may be used to examine the
financial feasibility of the acquisition. To ascertain whether the purchase of assets is financially
justifiable, the company must predict the costs and benefits of the assets.
EXAMPLE 17.6 The Davis Company wants to buy certain fixed assets of Boris Company. However,
Boris wants to sell out its entire business. The balance sheet for Boris Company follows:
ASSETS
Cash $ 3,000
Accounts receivable 7,000
Inventories 12,000
Equipment 1 15,000
Equipment 2 25,000
Equipment 3 40,000
Building 100.000
Total assets $202,000
LIABILITIES AND
STOCKHOLDERS' EQUITY
Total liabilities $ 90,000
Total stockholders' equity 112,000
Total liabilities and stockholders'
equity $202,000
MERGERS AND ACQUISITIONS [CHAP. 17
420
Davis needs only equipment 2 and 3 and the building. The other assets excluding cash can be sold for $30,000.
The total cash received is therefore $33,000 ($30,000 + $3,000 initial cash balance). Boris wants $45,OOO for the
entire business. Davis will thus have to pay a total of $135,000, which is $9O,OOO in total liabilities and $45,000 for
its owners. The actual net cash outlay is therefore $102,000 ($135,000  $33,000). It is expected that the aftertax
cash inflows from the new equipment will be $25,000 per year for the next 6 years. The cost of capital is 10
percent.
The net present value associated with this acquisition follows:
Calculations Present Value
$102,000
$102,000 x 1
Year 0
+$25,000 X 4.355 + 108,875
Years 16
Net present value 6,875
+$
Since the net present value is positive, the acquisition is recommended.
EXAMPLE 17.7 Miles Corporation is thinking of acquiring Piston Corporation for $50,000. Piston has liabilities
of $75,000. Piston has equipment that Miles desires. The remaining assets would be sold for $58,000. By acquiring
the equipment, Miles will have an increase in cash flow of $17,000 each year for the next 12 years. The cost of capital
is 10 percent.
The net cost of the equipment is:
$5O,OOO + $75,000  $58,000 = $67,000
Miles should make the acquisition since, as indicated below, the net present value is positive.
Calculations Present Value
Year 0 $67,000 X 1 $ 67,000
+115,838
Years 112 +$17,000 X 6.814
Net present value +$ 48,838
Acquisition by Exchanging Stock
A company is often acquired by exchanging common stock. The exchange will be in accordance with
a predetermined ratio. The amount the acquiring firm offers for each share of the acquired business is
usually more than the current market price of the traded shares. The ratio of exchange is equal to:
Amount paid per share of the acquired company
Market price of the acquiring companyâ€™s shares
EXAMPLE 17.8 Company A wants to acquire company B. Company A s stock sells for $80 per share. Company
Bâ€™s stock sells for $55 per share. Because of the merger negotiations, company A offers $60 per share. The
acquisition is made through an exchange of securities.
Ratio of exchange = amount paid per share of the acquired company  $60
= 0.75
market price of the acquiring companyâ€™s shares $80
Company A must exchange 0.75 share of its stock for one share of company Bâ€™s stock.
17.5 THE EFFECT OF A MERGER ON EARNINGS PER SHARE AND MARKET PRICE
PER SHARE OF STOCK
When a merger takes place, there may be a favorable or unfavorable effect on net income and
market price per share of stock. The effect on earnings per share can easily be seen in Example 17.9.
421
CHAR 171 MERGERS AND ACQUISITIONS
EXAMPLE 17.9 The following data are presented:
Company Y
Company X
$30,000 $54,000
Net income
Shares outstanding 4,000 990
$7.50 $6.00
Earnings per share
10 12.5
P/E ratio
Market price $75 $75
Company Y is the acquiring company and will exchange its shares for company X's shares on a oneforone
basis. The exchange ratio is based on the market prices of X and Y.The impact on EPS follows:
EPS Prior EPS Subsequent
Y Shares Owned
to Merger to Merger
after Merger
X stockholders 4,000 $7.50 $6.46"
Y stockholders 9,000 $6.00 $6.46"

13,000
Total
"Total net income is calculated as follows:
$30,000
4,000 shares X $7.50
54,000
9O O shares X $6.00
,O
New EPS $84,000
total net income = OOO
$84,
 $6.46
EPS =
total shares 13,000
EPS decreases by $1.04 for X stockholders but increases by $0.46 for Y stockholders.
The impact on market price is not clear. Assuming the combined company has the same PIE ratio as that of
company Y, the market price per share will be $80.75 (12.5 X $6.46). In this example, the stockholders of each firm
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