Discussion
Company A has 2,000 shares outstanding at a market price of $20 each and total earnings of $4,000. Company B has 1,000 shares outstanding at a market price of $10 each and total earnings of $2,000.
Company A acquires B by offering one (new) share of A for every two shares of B, so that 2,500 shares of A are outstanding after the merger. Suppose that the merger really does increase the value of the combined firms by $20,000. What is the cost of the merger?
Answer: D
Correct answer: $4,000
With a share exchange the cost depends on what fraction of the merged firm B’s shareholders receive. They get 500 of the 2,500 shares, that is 20 per cent, and the merged firm is now worth 50,000 + 20,000 = $70,000. So they receive 0.20 x 70,000 = $14,000 for a firm worth $10,000, and the cost is $4,000. The point of the calculation is that in a share deal the cost rises with the gain, because the seller shares in it.
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