The Chocolate Ice Cream Company and the Vanilla Ice Cream Company have agreed to
ID: 2711880 • Letter: T
Question
The Chocolate Ice Cream Company and the Vanilla Ice Cream Company have agreed to merge and form Fudge Swirl Consolidated. Both companies are exactly alike except that they are located in different towns. The end-of-period value of each firm is determined by the weather, as shown below. There will be no synergy to the merger.
State
Probability
Value
Rainy
.2
$380,000
Warm
.3
$560,000
Hot
.5
$1,070,000
The weather conditions in each town are independent of those in the other. Furthermore, each company has an outstanding debt claim of $560,000. Assume that no premiums are paid in the merger.
A. What are the possible values of the combined company? (Do not round intermediate calculations.)
Possible states
Joint Value
Rain-Rain
Rain-Warm
Rain-Hot
Warm-Warm
Warm-Hot
Hot-Hot
B. What are the possible values of end-of-period debt values and stock values after the merger? (Leave no cells blank - be certain to enter "0" wherever required. Do not round intermediate calculations.)
Debt Value
Stock Value
Rain-Rain
Rain-Warm
Rain-Hot
Warm-Warm
Warm-Hot
Hot-Hot
C. How much do stockholders and bondholders each gain or lose if the merger is undertaken? (Negative amount should be indicated by a minus sign. Do not round intermediate calculations)
Bondholders gain or loss is
Stockholders gain or loss is
State
Probability
Value
Rainy
.2
$380,000
Warm
.3
$560,000
Hot
.5
$1,070,000
Explanation / Answer
Value of the combined company is calculated in the below table
The joint values are the sums of the values of the two companies for the particular state.
If a firm cannot service its debt, the bondholders receive the value of the assets. Thus, the value of the debt is the value of the company if the face value of the debt is greater than the value of the company. If the value of the company is greater than the value of the debt, the value of the debt is its face value. Here, the value of the common stock is always the residual value of the firm over the value of the debt
Joint probabilities are calculated in below table
Rain Rain = 0.2 * 0.2 = 0.04, similarly for other states
Individual Debt value = 0.2*(380000) + 0.3*560000 + 0.5 * 560000 = 524,000
For the meger, debt value individually = 524,000 * 2 = 1,048,000
Total debt value post-merger = Probability * debt value
These are available in 2 tables above
So Total debt value post-merger = 747,600
Bond holders are loosing 1,048,000 - 747,600 = 300,400 loss
Stock holders are gaining = 300,400 gain
Possible State Joint Value Debt Value Stock Value Rain-Rain 760,000 760,000 - Rain-Warm 940,000 940,000 - Rain-Hot 1,450,000 1,120,000 330,000 Warm-Warm 1,120,000 1,120,000 - Warm-Hot 1,630,000 1,120,000 510,000 Hot-Hot 2,140,000 1,120,000 1,020,000