Discussion
Firm A has 100 shares outstanding at a market price of $100 each and total earnings of $600. Firm B has 100 shares outstanding at a market price of $16 each and total earnings of $200. The merger is expected to produce synergies with a present value of $600.
Calculate the post-merger price-earnings ratio assuming cash is used in the acquisition at $20 per share for Firm B.
Answer: A
Correct answer: 12.75
The merged firm earns 600 + 200 = $800 on 100 shares, so earnings per share are $8, and the price is $102. The ratio is 102/8 = 12.75. Note that it has fallen from A’s pre-merger 16.7, because A has bought a firm on a much lower multiple - the arithmetic that lies behind the bootstrap effect.
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