In early 2011 Giant Inc.\'s management was considering making an offer to buy Mi
ID: 2738027 • Letter: I
Question
In early 2011 Giant Inc.'s management was considering making an offer to buy Micro Corporation. Micro's projected operating income (EBIT) for 2011 was $30 million, but Giant believes that if the two firms were merged, it could consolidate some operations, reduce Micro's expenses, and raise its EBIT to $35 million. Neither company uses any debt, and they both pay income taxes at a 35% rate. Giant has a better reputation among investors, who regard it as very well managed and not very risky, so its stock has a P/E ratio of 12 versus a P/E of 9 for Micro. Since Giant's management would be running the entire enterprise after a merger, investors would value the resulting corporation based on Giant's P/E. If Micro has 10 million shares outstanding, by how much should the merger increase its share price, assuming all of the synergy will go to its stockholders?
Explanation / Answer
initial price of micro -> P/E= 9 -> P = 9*30 million*(0.65)/10million -> Pi = $17.55
for getting price of micro after merger, use PE ratio of 10.25, and E= 35*0.65/10
Pf = 10.25*35*0.65/10 = $23.32
increase in share price = Pf-Pi = $5.47