Question 22.2: Consider two corporations that both have earnings of $5 per ...
Consider two corporations that both have earnings of $5 per share. The first firm, OldWorld Enterprises, is a mature company with few growth opportunities. It has 1 million shares that are currently outstanding, priced at $60 per share. The second company, NewWorld Corporation, is a young company with much more lucrative growth opportunities. Consequently, it has a higher value: Although it has the same number of shares outstanding, its stock price is $100 per share. Assume NewWorld acquires OldWorld using its own stock, and the takeover adds no value. In a perfect market, what is the value of NewWorld after the acquisition? At current market prices, how many shares must NewWorld offer to OldWorld’s shareholders in exchange for their shares? Finally, what are NewWorld’s earnings per share after the acquisition?
PLAN
Because the takeover adds no value, the post-takeover value of NewWorld is just the sum of the values of the two separate companies: 100 × 1 million + 60 × 1 million = $160 million. To acquire OldWorld, NewWorld must pay $60 million. First, we need to calculate how many shares NewWorld must issue to pay OldWorld shareholders $60 million. The ratio of NewWorld shares issued to OldWorld Shares will give us the exchange ratio. Once we know how many new shares will be issued, we can divide the total earnings of the combined company by the new total number of shares outstanding to get the earnings per share.
EXECUTE
At its pre-takeover stock price of $100 per share, the deal requires issuing 600,000 shares ($60 million/$100 = 600,000). As a group, OldWorld’s shareholders will then exchange 1 million shares in OldWorld for 600,000 shares in NewWorld. The exchange ratio is the ratio of issued shares to exchanged shares: 600,000/1 million = 0.6. Therefore, each OldWorld shareholder will get 0.6 shares in NewWorld for each 1 share in OldWorld. Notice that the price per share of NewWorld stock is the same after the takeover: The new value of NewWorld is $160 million and there are 1.6 million shares outstanding, giving it a stock price of $100 per share.
However, NewWorld’s earnings per share have changed. Prior to the takeover, both companies earned $5/share × 1 million shares = $5 million. The combined corporation thus earns $10 million. There are 1.6 million shares outstanding after the takeover, so NewWorld’s post-takeover earnings per share are
EPS = \frac{\$10 \text{ million}}{1.6 \text{ million shares}} = $6.25/share
By taking over OldWorld, NewWorld has raised its earnings per share by $1.25.
EVALUATE
Because no value was created, we can think of the combined company as simply a portfolio of NewWorld and OldWorld. Although the portfolio has higher total earnings per share, it also has lower growth because we have combined the low-growth OldWorid with the high-growth NewWorld. The higher current earnings per share has come at a price—lower earnings per share growth.