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 stock price of $40 per share. Assume Bob acquires Cat using its own stock 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) 1 share of new company after takeover for each share of Cat Enterprises.
B) 0.625 shares of new company after takeover for each share of Cat Enterprises.
C) 1.6 shares of new company after takeover for each share of Cat Enterprises.
D) 0.3846 shares of new company after takeover for each share of Cat Enterprises.

Question

Quizplus · Accepted Answer

B) The post takeover value of new company after takeover is the sum of the values of the two separate companies = (5 million × $25) + (5 million × $40) = $325 million.
At its pretakeover price of $40, shares issued by Bob pay Cat shareholders $125 million
= $125 million / $40 = 3.125 million shares.
The exchange ratio is the ratio of issued shares in exchange 5 million shares
= 3.125 million /5 million = 0.625 shares,
So each shareholder of Cat will get 0.625 shares of new company after takeover.

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