CFA Level 2 - Corporate Finance Session 9 - Reading 32

CFA Level 2 – Corporate Finance, Session 9 – Reading 32

(Practice Questions, Sample Questions)

1. Which of the following is NOT a commonly used merger classification describing forms of integration?

A)Regulatory merger. (Regulatory merger is not a commonly used merger classification. Both remaining answers are commonly used to describe the form of integration following a merger)
B)Consolidation.
C)Subsidiary merger.
2. Suppose that a manufacturer of steel bridge beams (BridgeCo) acquires its main supplier of the steel (SteelCo) used to make the beams. After the merger is completed, the only surviving entity is BridgeCo.

This is best described as a:

A)subsidiary merger.
B)horizontal merger.
C)vertical merger. (This is best described as a vertical merger, since BridgeCo is purchasing a company from which it gets production inputs. It could also be described as a statutory merger, since only the acquiring firm is in existence following the combination)
3. A combination of two firms in entirely different industries is called a:

A)vertical merger.
B)horizontal merger.
C)conglomerate merger (When two firms in entirely different industries merge, it is called a conglomerate merger)
4. Burger World is interested in obtaining a controlling interest in Snappy Auto Repair. This potential merger is best described as a:

A)conglomerate.(Combining firms in separate industries represents a conglomerate merger)
B)horizontal merger.
C)vertical merger
5. Which type of merger is most likely when the motivation for merging is to bootstrap earnings per share (EPS), and what does this imply about the lifecycle stage of the acquirer and the target?

A)Conglomerate and same stage.

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B)Conglomerate and different stages. (In order for EPS bootstrapping to occur, the target must have a lower price-to-earnings (P/E) ratio than the acquirer. Since firms in the same industry are more likely to have similar P/Es, this makes a horizontal merger less likely. The differential in P/Es implies a differing level of expected growth. All else being equal, this suggests that the firms will be in different lifecycle stages)
C)Horizontal and different stages

6. Grogan Medical Devices (GMD) is a leading manufacturer of cardiac treatment devices including defibrillators and pacemakers. Over the last three months, problems have been discovered with a GMD defibrillator model, resulting in a massive product recall. As a result of the recall, and the potential impact on future sales, the price of GMD’s stock dropped to its current level of $18 per share.
As a result of the drop in the price of the stock, two firms have expressed interest in acquiring GMD. Paulsgrove Corporation (Paulsgrove) is a large health care conglomerate with businesses in consumer products, pharmaceuticals, and cardiac treatment devices. The management team at Paulsgrove sees a merger with GMD as a means to combine its current defibrillator and pacemaker operations with those of GMD, creating the worldwide leader in those two product lines.
Bailey Scientific (Bailey) is a specialty manufacturer of stents used to open clogged arteries during heart surgery. Bailey sees a merger with GMD as a natural extension of its existing heart treatment product line, and believes using its existing stent product specialists to also market defibrillators and pacemakers could result in significant cost savings. They also believe that there would be benefits from expanding the size of Bailey’s operations. What would be the best description of the type of merger if GMD were to merge Paulsgrove or if GMD were to merge with Bailey respectively?
Either a merger with Paulsgrove or a merger with Bailey would be described as a horizontal merger. In a horizontal merger, the two businesses operate in the same or similar industries. Even though Paulsgrove is already a conglomerate firm, the purpose of the merger would be to combine Paulsgrove’s existing defibrillator and pacemaker business with that of GMD. A merger with Bailey would also be considered a horizontal merger as the two firms operate in similar industries. Note that the primary benefit for either Paulsgrove or Bailey is economies of scale, which is typically the strategy behind a pure horizontal merger. With a vertical merger, a firm moves up or down the supply chain (i.e., acquiring a firm that makes the equipment to make pacemakers, or buying a hospital to distribute the products). With a conglomerate merger, the businesses operate in separate industries
7. Which of the following statements concerning the gains from a merger are least accurate?

A)In a stock offer, gains to the target shareholders are dependent upon the post-merger stock price of the acquirer.
B)In a stock offer, the target shareholder’s gains are less than those from a comparable cash offer. (In a stock offer, the target shareholder’s gains will generally exceed those from a comparable cash offer. This, of course, depends upon the acquirer’s stock price following the merger. But, if the exchange ratio is based upon the acquirer’s pre-merger price, and if the post-merger price exceeds the pre-merger price, the target’s gains from the stock offer should be greater than those from a cash offer)
C)In a cash offer, the target shareholder’s gains are capped at the amount of the takeover premium
8. Big Steel is considering making a bid for Small Steel. The following data applies to the analysis:
(B) (Gains to Small Steel = takeover premium = $4,400 – $4,000 = $400m.
Gains to Big Steel = synergies – takeover premium = $600 – $400 = $200)
9. Oak Industries is considering making a bid for Tidy Trim Makers. The following data applies to the analysis:[td=67]

A) $1,600m and $2,300m and be paid for with cash
B) $1,600m and $2,300m and be paid for with stock
C) $700m and $2,300m and be paid for with cash
(A)(The merger price should fall within the range of the pre-merger value of the target ($1,600m) and the pre-merger value plus the estimated synergies ($2,300m). Since the acquirer is confident that the synergies will be $700m or greater, they will most likely seek to pay in cash so that they capture any upside for themselves.)
10. Which of the following statements regarding merger synergies are least accurate?

A)The more confident the acquirer is that synergies will be realized, the more likely they will make a cash offer.
B)In a stock offer, if estimates regarding the value of the synergies are too high, the target shareholders will bear some of the downside.
C)In a stock offer, all of the risks and potential rewards shift to the target shareholders (In a stock offer, some of the risks and potential rewards shift to the target shareholders. Both remaining statements are correct as presented)
11. The theoretical price range for a merger transaction is between the pre-merger price of the target (VT), and:

A)VT + the takeover premium.
B)VT + synergies resulting from the merger – the takeover premium.
C)VT + synergies resulting from the merger (Assuming that the true intrinsic values and synergies from the takeover can be correctly estimated, the theoretical price range for a merger transaction is between a low of the pre-merger price of the target (VT), and a high of VT + synergies resulting from the merger. At the low, all of the gains from the merger accrue to the acquirer. At the high, all of the gains accrue to the target)
12. Based upon long-term stock performance following a merger, academic studies suggest that acquirers:

A)moderately outperform their peers, with slightly more than half exceeding their group.
B)significantly underperform their peers, with more than 60% lagging their group. (Based upon long-term (3-year) performance following a merger, academic studies suggest that acquirers significantly underperform their peers, with more than 60% performing worse than their peer group averages)
C)moderately underperform their peers, with slightly more than half lagging their group
13. Based upon short-term stock performance around the merger date, academic studies concerning the distribution of the benefits suggest that:

A)the acquirer usually loses value, but the target usually gains value. (Studies based upon short-term stock performance around the merger date suggest that the acquirer loses a small amount of value, while the target makes significant gains)
B)both parties usually gain value.
C)the target usually loses value, but the acquirer usually gains value
14. Empirical evidence suggests that the majority of the benefits from a merger accrue to the target firm’s shareholders. What does this suggest about the outcome of a competitive bidding process, and what does this imply with regard to the payment strategy and bidding strategy for prospective acquirers? It suggests that the:

A)target’s management is infected with pride, that the preferred payment method in competitive bidding should be stock, and that the bidder should be prepared to withdraw if the probable cost exceeds the target’s pre-merger value plus estimated synergies.
B)winner’s curse is real, that the preferred payment method in competitive bidding should be stock, and that the bidder should be prepared to withdraw if the probable cost exceeds the target’s pre-merger value plus estimated synergies. (If the values of the bids are, on average, correct, then the winner has, by definition, overpaid. This is the winner’s curse. Since the empirical evidence suggests that the process is risky for the bidder, the form of payment should be stock so that the risk is shared with the target’s shareholders. The bidder should be prepared to withdraw if the cost exceeds maximum fair value)
C)winner’s curse is real, that the preferred payment method in competitive bidding should be cash, and that the bidder should be prepared to withdraw if the probable cost exceeds the target’s pre-merger value plus estimated synergies
15. Which of the following statements regarding the distribution of the benefits from a merger are least accurate?

A)Short-term performance around the date of a merger suggests that target management suffers from reference dependence in attempting to extract value for shareholders. (Short-term performance around the date of a merger suggests that, on average, target shareholders benefit handsomely from the completion of a merger transaction. In fact, they appear to extract all of the benefits of the merger. Reference dependence is a behavioral finance term that does not appear to be applicable to target firm management in the case of mergers)
B)Long-term performance following a merger transaction suggests that the acquiring firm is unable to capture the synergies expected prior to the merger.
C)The winners curse implies that in a contested takeover, on average, the winning bidder overpays for the target
16. When a parent company sells a subsidiary or a coherent group of assets with a stated reason to provide a near-term infusion of cash, which method for selling the assets is most likely?

A)Spin-off.
B)Equity carve-out.
C)Divestiture (Spin-offs involve the issuance of shares in the new firm, and do not generate cash for the parent company. Hence, this can be ruled out if the intent is an infusion of cash. An equity carve-out will generate cash for the parent when the public offering is completed, but this can take time. A divestiture is typically a sale to another firm for cash, and is likely to be completed much more quickly than a carve-out. Therefore, if the intent is to provide a near-term infusion of cash, a divestiture is most likely)
17. The difference between a spin-off and a split-off is that in a spin-off:

A)the parent’s existing shareholders receive shares in the new firm on a pro-rata basis, whereas they must surrender their shares in the parent to obtain shares of the new firm in a split-off. (In a spin-off, shares of the new firm are distributed to the parent’s existing shareholders on a pro-rata basis. In a split-off, the parent’s existing shareholders must surrender their shares in the parent to obtain shares in the new firm)
B)shares in the new firm are distributed on a pro-rata basis to existing shareholders, but are sold via a public offering in a split-off.
C)the parent’s existing shareholders must surrender their shares in the parent to obtain shares of the new firm, whereas they receive shares in the new firm on a pro-rata basis in a split-off
18. The usual distinction between a divestiture and a spin-off is that a divestiture:

A)is the sale of a subsidiary for cash, whereas a spin-off involves the distribution of shares in the subsidiary to the parent’s existing shareholders. (Both actions involve the sale of a subsidiary or some coherent subset of the firm’s assets. In the case of a divestiture, the sale is usually for cash. In the case of a spin-off it involves the distribution of the new firm’s shares to the parent’s existing shareholders)
B)is a simple distribution of shares in the subsidiary to the parent’s existing shareholders, whereas a spin-off involves an exchange of the parent’s shares for shares of the subsidiary.
C)involves the distribution of shares in the subsidiary to the parent’s existing shareholders, whereas a spin-off is the sale of a subsidiary for cash

19. Insofar as reasons for divestitures are concerned, when a firm divests of assets because of reverse synergies, this is most consistent with the rationale of:

A)a lack of profitability.
B)assets no longer fitting the long-term strategy.
C)individual parts being worth more than the whole (Whereas synergies imply that the whole is worth more than the sum of the parts, reverse synergies imply that the whole is worth less than the sum of the parts. Therefore, the firm is better off selling the parts to which this applies because they are worth more separately than they are as a part of the firm)
20. Insofar as reasons for divestitures are concerned, when a firm divests of assets because of a desire to focus on its core business, this is most consistent with the rationale of:

A)individual parts being worth more than the whole.
B)assets no longer fitting the long-term strategy. (A stated desire to focus on the firm’s core business indicates that the assets being sold are not a part of the core business. Thus, the assets no longer fit the long-term strategy)
C)a lack of profitability.
21. Insofar as reasons for divestitures are concerned, when a firm divests of assets because of rising costs or a change in consumer tastes, this is most consistent with the rationale of:

A)assets no longer fitting the long-term strategy.
B)individual parts are worth more than the whole.
C)a lack of profitability (Changes in consumer tastes imply that sales are below expectations, while rising costs are self-explanatory. In either case, this seems to indicate that profitability objectives are not being met)