Consider two firms, Bob Company and Cat Enterprises, both with earnings of $10 per share and 5 million shares outstanding. Cat is a mature company with few growth opportunities and a stock price of $25 per share. Bob is a new firm with much higher growth opportunities and a share price of $40 per share. Assume Bob acquires Cat using its own shares and the takeover adds no value. In a perfect capital market, how many shares must Bob offer Cat's shareholders in exchange for their shares?
A)0.625 shares of BobCat company for each share of Cat Enterprises
B)1 share of BobCat for each share of Cat Enterprises
C)0.3846 shares of BobCat company for each share of Cat Enterprises
D)1.6 shares of BobCat company for each share of Cat Enterprises

Question

Quizplus · Accepted Answer

The correct answer is A because the takeover adds no value, so the combined firm should have the same market value as the two separate firms. The market value of Cat is $25 * 5 million = $125 million. The market value of Bob is $40 * 5 million = $200 million. The combined firm should have a market value of $125 million + $200 million = $325 million. The number of shares of the combined firm should be 5 million + 5 million = 10 million. The share price of the combined firm should be $325 million / 10 million = $32.50. The number of shares of Bob that must be offered to Cat's shareholders is $25 / $32.50 = 0.625 shares of Bob for each share of Cat.

Consider Two Firms, Bob Company and Cat Enterprises, Both with Earnings