Firm A does well in a boom economy. Firm B does well in a bust economy. The probability of a boom is 50%. The end of period values of the two firms depend on the economy as shown below: Both firms have debt outstanding with a face value of $1,000. In order to diversify, the two firms have proposed a merger. The NPV of the merger is zero. Which of the following statements is correct?

Question

Firm A does well in a boom economy. Firm B does well in a bust economy. The probability of a boom is 50%. The end of period values of the two firms depend on the economy as shown below:  Both firms have debt outstanding with a face value of $1,000. In order to diversify, the two firms have proposed a merger. The NPV of the merger is zero. Which of the following statements is correct?

Quizplus · Accepted Answer

The merger would reduce the overall risk of the two firms since they have opposite sensitivities to the economy. Therefore, the bondholders would stand to gain from the merger since the risk of default would be lower. The stockholders may also benefit from the merger due to the reduced risk, but it cannot be assumed that the probability of bankruptcy becomes zero. The NPV being zero does not necessarily mean that the stockholders are indifferent to the merger.

Firm a Does Well in a Boom Economy