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Exam 21: Mergers, Lbos, Divestitures, and Holding Companies

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Question 1

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Kelly Tubes is considering a merger with Reilly Tires. Reilly's market-determined beta is 0.9, and the firm currently is financed with 20% debt, at an interest rate of 8%, and its tax rate is 25%. If Kelly acquires Reilly, it will increase the debt to 60%, at an interest rate of 9%, and the tax rate will increase to 35%. The risk-free rate is 6% and the market risk premium is 4%. What will Reilly's required rate of return on equity be after it is acquired?

A) 7.4%
B) 8.9%
C) 9.3%
D) 9.6%
E) 9.7%

F) D) and E)
G) C) and D)

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Question 2

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The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if it had no debt.

A) True
B) False

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Question 3

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Most defensive mergers occur as a result of managers' actions to maximize shareholders' wealth.

Coca-Cola's acquisition of Columbia Pictures and its announcement that it would operate its new subsidiary separately could be described as primarily a financial merger.

A congeneric merger is one where the merging firms operate in related businesses but do not necessarily produce the same products or have a producer-supplier relationship.

Leveraged buyouts (LBOs) occur when a firm's managers, generally backed by private equity groups, try to gain control of a publicly owned company by buying out the public shareholders using large amounts of borrowed money.

Since the primary rationale for any operating merger is synergy, in planning such mergers, the development of accurate pro forma cash flows is the single most important action.

Only if a target firm's value is greater to the acquiring firm than its market value as a separate entity will a merger be financially justified.

Which of the following statements about valuing a firm using the APV approach is most CORRECT?

In a merger with true synergies, the post-merger value exceeds the sum of the separate companies' pre-merger values.

Any goodwill created in a merger must be amortized over its expected life, usually 40 years, for shareholder reporting purposes.

Since a manager's central goal is to maximize the firm's stock price, any merger offer that provides stockholders with significant gains over the current stock price will be approved by the current management team.

Merger activity is likely to heat up when interest rates are high because target firms can expect to receive an especially high premium over the pre-announcement stock price.

A joint venture is one in which 2, or sometimes more, independent companies agree to combine resources in order to achieve a specific objective, usually limited in scope.

The distribution of synergistic gains between the stockholders of 2 merged firms is almost always based strictly on their respective market values before the announcement of the merger.

A two-tier merger offer is one where the acquiring company offers to purchase the target company in a two-part transaction. Cash is paid to some stockholders, bonds are issued to others, but the total values of each part of the transaction are equal.

The 3 main advantages of holding companies are (1) control with fractional ownership, (2) taxation benefits, and (3) isolation of operating risks.

A spin-off is a type of divestiture in which the assets of a division are sold to another firm.

A conglomerate merger occurs when two firms with either a horizontal or a vertical business relationship combine.

Discounted cash flow methods are not appropriate for evaluating mergers because the cash flows are uncertain and the discount rate can only be determined after the merger is consummated.