Problem
BigCo is purchasing LittleCo. BigCo has a share price of $20, with 100,000 shares outstanding. LittleCo has a share price of $10, with 75,000 shares outstanding. Big is purchasing all of Little's shares, paying 80% in cash and 20% in equity. Big's cost of capital is 12%, Little's is 16%. If the merger happens, there is a 50% chance that starting 5 years from today, Big's yearly net income will go up by $60,000 per year. Big is paying a $1.25/share premium for Little.
1) What is the NPV of this merger to Big?
2) What is the largest premium Big could justify offering for Little?
3) How many new shares should Big issue to compensate Little?
4) What are two things that Big's management probably believes if they wish to pay for Little mostly using equity?