Question

Suppose you work as a strategic financial manager at Nadia Inc., a large telecommunications firm which is considering making an offer to purchase Shaan Inc. a smaller network company. You have collected the following information for this important financial decision: Nadia Shaan Price-earnings ratio 8 6 Shares outstanding 500,000 220,000 Earnings $1,500,000 $440,000 Securities analysts expect the earnings and dividends (currently $1 per share) of Shaan to grow at a constant rate of 4% each year. Nadia management believes that its acquisition of Shaan will generate some economies of scale increasing Shaan's dividend per share growth rate to 6% per year. Based on this belief, Nadia is considering the following two alternative ways of acquiring Shaan: Alternative 1 Acquire Shaan by paying S15 cash per share for Shaan's stock. Alternative 2 Acquire Shaan by share exchange ratio of 1:4 (i.e. one share of Nadia for 4 shares of Shaan). Required a. Which of the above two alternatives Should Nadia choose? Support your answer with calculations b. At what exchange ratio of Nadia's shares to Shaan's shares would the shareholders of Shaan be indifferent between Nadia's cash or stock offer for their stock? Show calculations to support your answer.

Answer 1

In order to be able to choose between the alternatives, lets first find out the effective value per share (Shaan's value per share) that Nadia would offer to Shaan in each of these alternatives. The one which is cheaper is the one which we should prefer for acquiring Shaan.

As per the data provided, with Earnings of $440,000 and Price-earnings ratio of 6 times, the Price of all shares outstanding comes to $440,000 x 6 = $2,640,000

Since 220,000 shares are outstanding, Shaan's current share price = $2,640,000/220,000 = $12/share

Using similar steps, we can arrive at Nadia's current share price = ($1,500,000 x 8) / 500,000 = $24/share

In Alternative 1, since Nadia offers $15 cash per share for Shaan's stock, Nadia is paying a premium of $3/share (i.e. $15 - $12) to Shaan.

In Alternative 2, Nadia offers 1 share of Nadia for 4 shares of Shaan. Based on Nadia's current price of $24/share, this means that Shaan is valued at $24 / 4 = $6 per share. So Nadia will acquire Shaan at a discount of $6/share (i.e. $12 - $6).

Answer a. So, since Alternative 2 is significantly better and cheaper than Alternative 1, Nadia should choose Alternative 2.

Answer b. In case of the cash offer, we saw that Nadia was offering $15/share to Shaan for acquiring it. So the exchange ratio at which Shaan's shareholders would be indifferent to the cash or stock offer should be such that it still values Shaan's share at $15/share. So if we just take the ratio of the desired share price of $15/share for Shaan to Nadia's share price, we arrive at $15 / $24 = 5. : 8

Basis the above calculating, Nadia would have to acquire Shaan by share exchange ratio of 5:8 (i.e. 5 shares of Nadia for 8 shares of Shaan). At this exchange ratio, Shaan's shareholders would be indifferent between Nadia's cash or stock offer for their stock.