Reference no: EM133069286
Question - Company A and Company B will each company operate for one year and then cease to exist. Company A's operations will generate cash flow of $100M if the economy is in an expansion and $40M if the economy is in a recession. Company B's operations will generate cash flow of $20M if the economy is an expansion and $110M if the economy is in a recession. An expansion and a recession are equally likely. Company A has debt with a face value of $50M to be repaid at the end of the year. Company B also has debt with a face value of $50M to be repaid at the end of the year. Assume no discounting, no taxes, and no financial distress costs.
(a) What is the current market value of Company A's equity? Company A's debt? Company B's equity? Company B's debt?
(b) Now, suppose that Company A announces that it is acquiring Company B and merging it into its own operations. The merger will not change the cash flows that either Company A's or B's operations will generate. That is, the combined company will generate cash flows equal to the sum of Company A's and B's standalone cash flows. Company A will pay the market price of Company B's equity that you calculated in part (a) to acquire Company B. Specifically, it will give Company B's shareholders equity in the merged company that is worth Company B's standalone market value. Company A will also assume Company B's debt. Immediately after the announcement, but before the transaction takes place, what will be the market value of Company A's equity? Company A's debt? Company B's debt?
(c) Finally, suppose that Company A announces that it acquiring Company B for the same price as in part (b), but instead of combining the two companies, as in part (b), Company A will maintain Company B as a separate wholly-owned subsidiary. Company A will not be responsible for its subsidiary's (i.e., Company B's) debt, and the subsidiary will not be responsible for Company A's debt. The subsidiary would pay any cash remaining after repaying its creditor at the end of the year to Company A as a dividend, which Company A would then use to repay its own debt if its own cash flow is insufficient. The acquisition terms are the same as in part (b). Immediately after the announcement, but before the transaction takes place, what will be the market value of Company A's equity? Company A's debt? Company B's debt?