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?
A) The stockholders are indifferent to merger since the NPV is zero.
B) The bondholders are indifferent to merger since the NPV is zero.
C) The bondholders stand to gain because the risk of the combined firm is less.
D) The stockholders stand to gain because the probability of bankruptcy becomes zero after the merger.

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?
A) The stockholders are indifferent to merger since the NPV is zero. 
B) The bondholders are indifferent to merger since the NPV is zero. 
C) The bondholders stand to gain because the risk of the combined firm is less. 
D) The stockholders stand to gain because the probability of bankruptcy becomes zero after the merger.

Quizplus · Accepted Answer

Since Firm A and Firm B have debt outstanding, the bondholders are affected by the proposed merger. According to the table, Firm A has a higher probability of default in a bust economy. By merging with Firm B, the risk of default decreases as the probability of a bust reduces. Hence the bondholders stand to gain because the risk of the combined firm is less. The NPV being zero doesn't affect the bondholders, but it affects the stockholders, who may be indifferent to the merger. Statement D is incorrect as the probability of bankruptcy does not become zero after the merger.

Firm a Does Well in a Boom Economy