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Chapter 5: 11BP (page 653)

Assume the Knight Corporation is considering the acquisition of Day Inc. The expected earnings per share for the Knight Corporation will be \(4.00 with or without the merger. However, the standard deviation of the earnings will go from \)2.40 to $1.60 with the merger because the two firms are negatively correlated.

a.Compute the coefficient of variation for the Knight Corporation before and after the merger (consult Chapter 13 to review statistical concepts if necessary).

b.Discuss the possible impact on Knight鈥檚 postmerger P/E ratio, assuming investors are risk-averse.

Short Answer

Expert verified

Coefficient of variance before and after merger are $0.60 and $0.40 respectively. The post-merger coefficient of variation of the company is $0.40.

Step by step solution

01

Definition of coefficient of variation

The coefficient variation means the ratio of standard deviation to the earnings per share.

02

Calculation of the coefficient of variation

Coefficient of variation before the merger

CoefficientofVariation=StandardDeviationEarningsPerShare=$2.40$4.00=0.60

Post-merger coefficient of variation,

CoefficientofVariation=StandardDeviationEarningsPerShare=$1.60$4.00=0.40

03

Effect on the P/E ratio

The P/E ratio of Knight is increase because the risk-averse investors reduces the risk.

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Most popular questions from this chapter

Differentiate between the spot exchange rate and the forward exchange rate.

The Office Automation Corporation is considering a foreign investment. The initial cash outlay will be \(10 million. The current foreign exchange rate is 2 ugans 5 \)1. Thus the investment in foreign currency will be 20 million ugans. The assets have a useful life of five years and no expected salvage value. The firm uses a straight-line method of depreciation. Sales are expected to be 20 million ugans and operating cash expenses 10 million ugans every year for five years. The foreign income tax rate is 25 percent. The foreign subsidiary will repatriate all aftertax profits to Office Automation in the form of dividends. Furthermore, the depreciation cash flows (equal to each year鈥檚 depreciation) will be repatriated during the same year they accrue to the foreign subsidiary. The applicable cost of capital that reflects the riskiness of the cash flows is 16 percent. The U.S. tax rate is 40 percent of foreign earnings before taxes.

  1. Should the Office Automation Corporation undertake the investment if the foreign exchange rate is expected to remain constant during the five year period?
  2. Should Office Automation undertake the investment if the foreign exchange rate is expected to be as follows?

Year 0 .......................... \(152.0ugans

Year 1 .......................... \)152.2ugans

Year 2 .......................... \(152.4ugans

Year 3 .......................... \)152.7ugans

Year 4 .......................... \(152.9ugans

Year 5 .......................... \)1 5 3.2 ugans

What is a letter of credit?

Worldwide Scientific Equipment is considering a cash acquisition of Medical Labs for \(1.6 million. Medical Labs will provide the following pattern of cash inflows and synergistic benefits for the next 25 years. There is no tax loss carryforward.

Years 1鈥�5 6鈥�15 16鈥�25 Cash inflow (aftertax) ...................... \)150,000 \(170,000 \)210,000 Synergistic benefits (aftertax) ......... 20,000 30,000 50,000

The cost of capital for the acquiring firm is 11 percent. Compute the net present value. Should the merger be undertaken?

Chicago Savings Corp. is planning to make an offer for Ernie鈥檚 Bank & Trust. The stock of Ernie鈥檚 Bank & Trust is currently selling for \(44 a share.

a.If the tender offer is planned at a premium of 50 percent over market price, what will be the value offered per share for Ernie鈥檚 Bank & Trust?

b.Suppose before the offer is actually announced, the stock price of Ernie鈥檚 Bank & Trust goes to \)60 because of strong merger rumors. If you buy the stock at that price and the merger goes through (at the price computed in part a), what will be your percentage gain?

c.Because there is always the possibility that the merger could be called off after it is announced, you also want to consider your percentage loss if that happens. Assume you buy the stock at \(60 and it falls back to its original value after the merger cancellation, what will be your percentage loss?

d. If there is an 80 percent probability that the merger will go through when you buy the stock at \)60, and only a 20 percent chance that it will be called off, does this appear to be a good investment? Compute the expected value of the return on the investment.
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