2013 FRM L2 GARP Practice exam Q14

[jennyshen]

GV and LM are both leading car manufactures in hybird car designs. Earlier this year, both companies introduced new hybird models that are comparatble to each other in almost every category. However, after both companies release prividing for their new models,LM'S model is 20% less expensive thatn GV'S. As a result, GV'S stock price decliented sharply while LM'S stocks price rose dramatically. Subsequenct annoce that they have entered into merger discussion where the terms of the planned merger would give GB shareholders 1 share of LM per 3 shares of GB previously held. Post the announcement, GV'S stock is treading at USD 20 and LM's stock is trading at USD 58. If you are confident that the merger will be completed, assuming zero transaction costs, which of the following investment should you make?

A BUY 300 shares of GV and short 100 shares of LM
B Short 300 shares of GV and buy 100 shares of LM
C Buy 300 shares of GV and buy 100 shares of LM
D Short 300 share of GV and short 100 shares of LM


The correct answer is B. When i first saw this question, I chose A . I remeber a similar sample is coverd in the note which says t the target firm's stock price is going up and the acquirer's firm's stock price is goring to drop. So in the sample of the notes, they buy the targe firm's stock and sell the acquired firm's stock. My question is why it doesn't work in this case?

 

[Remy D]

In a normal case, the acquirer will pay a premium for the target. So when the announcement is made, the stock price of the target goes up and of the acquirer down. So suppose in this case, before the merger was announced, the price for GV is 15 and 60 for LM. After the announcement the price for GV goes up and the price of LM will decline so that the ratio of the prices will converge to 3, but not exactly 3 because the deal could still fail, so the ratio is a bit more than 3. In this example, the ratio is less than 3 so not a realistic example.

 

[Thomas Obitz]

The merger is actually an acquisition of GV by LM, using shares. You get 1 share of LM per 3 shares of GV, hence the price of LM should be 3 times the price of GB. As it is lower, you buy LM and short GV.

 

[saritay]

I have the same question as Jennyshen. When I first did the question, I selected A as well as in a merger situation, you go long the target and short the buyer. I am not clear as to why the answer is not a? Anyone knows?

David, would you clarify please?
Best,
S

 

[ShaktiRathore]

Hi, a possible explanation i don't know if its 100% right but my point of view
The option A is applicable when the merger is not yet announced that merger once announced the target Co share will rise in value while acquirer shares will decline somewhat but once the merger is announced there is risk that merger will go through or not so that the prices of two will not be in exact ratio of 3:1 but a little different than this. So there is discount at which the target shares trade at here price of 20 but the actual price can be say 22 (merger goes through)and corresponding share price of acquirer shall be three times 22 which is 66, so long acquirer and short target so net profit seems possible but its also possible that merger does not goes through in that case so that target price declines to say 15 and acquirer stays at 58 then we shall gain on short position on target and there is no profit from long an acquirer, but there is overall profit. Thus for me option b is more plausible that is short target GV and long acquirer LM. Option A is true when there is no announcement of merger and there seems merger possible and thats when we can go long target and short acquirer.
thanks

 

[cdbsmith]

Hi Jennyshen,

Your initial approach to the question is not technically incorrect. However, the scenario you described (stock price of the acquirer usually drops while the stock price for the target usually rises when an acquisition is announced) is usually associated with firms that try to acquirer targets that are in completely different industries (i.e., the acquirer and the target do not operate in the same industry). The reason for this is that investors generally believe (with some validity) that the acquirer's valuation of the target is higher than it should be. However, if the acquirer and target are in the same industry it is expected that some synergies (e.g., economies of scale, access to more customers via sales distribution channels, reduction of product costs by acquiring a supplier, etc.) could be gained. This type of acquisition should be viewed positively by investors assuming the valuations are reasonable.

Based on the question, it appears that LM and GV are competitors in the same industry. Therefore, it would be completely reasonable for LM to expect some synergies from the merger as the combined firm should, at a minimum, experience lower operating (and more importantly lower inventory/production) costs. The only question is how much. Based on LM's reduced post-announcement share price, we can assume that investors do not agree with LM's valuations. That is, investors must believe that the expected synergies to gained from the merger will be lower than what LM has calculated (estimated).

To illustrate, let's assume that LM's and GV's pre-announcement stock prices were $60 and $18, respectively. Let's also assume that LM has 1M shares outstanding and GB has 1.5M shares outstanding. Therefore, LM's and GB's pre-announcement market value is $60M (1M share x $60/share) and GB's pre-announcement market value is $27M (1.5M x $18/share). To facilitate the proposed merger, LM anf GV have agreed on a 1 for 3 share exchange. Let's further assume that LM believes (based on its valuation calculations and assumptions) that the post-merger value will be 92M ($60M + $27M + $5M) due to the syngeries it expects to gain from the merger.

Now, the obvious questions is, based on LM's and GV's 1 for 3 share exchange acquisition agreement, which fim's shareholders will capture the majority of the gain (i.e., $5M gain from synergy effects). Recall the three basic ways to complete a merger/acquisition are cash, stock or a combination of cash and stock. Depending on the acquirer's confidence in the its valuation of the target will determine what payment method should be used. That is, if the acquirer is highly confident that the expected syngeries will be realized, cash will be preferred payment method as it limits that share of the gain that the target firm's shareholders will get since their shares will be purchased. On the other hand, if the acquirer is not very confident that the expected synergies will be realized, a stock offering will be the preferred payment method as the target firm's shareholders will now share in the risk (and reward) if things go as planned. Sometimes, the acquirer and target will agree to use cash and stock to complete the merger.

In this case, LM has agreed to use stock to acquire GV. Therefore, LM will issue 500K (1/3 * 1.5M) new shares to acquire GV. Therefore, the total shares outstanding post-merger will be 1.5M (1M + 500K). The expected post-merger share price is now $61.33 ($92M/1.5M shares). Therefore, the price that LM will pay to acquire GV is $30.67M ($61.33 x 500K shares). Therefore, LM will pay a premium of $3.67M ($30.67M – $27M). This effectively means that LM will pay $20.44/share to acquire all of GV’s outstanding shares, which is $2.44 more than the pre-announcement market price ($18/share). As a result, GV shareholders will capture $3.67M of the expected 5M gain from the acquisition. LM will only capture $1.33M. Investors will also perform their own valuations and will quickly determine if LM’s post-merger valuation is realistic and whether the price to acquire GV is too high.

Based on the question, we can assume that investors to not agree with LM’s valuation. However, they would definitely want to take advantage of the overly high price that LM will pay to acquire GV and quickly capture the premium (i.e.,profit). This will drive investor to buy (long) GV’s shares. Likewise, investors also believe that LM is now overvalued and will sell (short) their respective shares. This is why GV’s share price has risen and LM’s share price has fallen.

Your choice of answer "A" makes only if you buy the GV shares at the pre-announcement share price of $18 and also sell the LM shares at the pre-announcement share price of $60. But, the question clearly states that the announcement has been made and the share prices now reflect the new information. Therefore, answer B makes sense as investors will now want to short (sell) GV shares for the price of $20 (vs. $18). Likewise, investors will want to buy LM shares at the price of $58 (vs. $60). Remember, the strategy is always to buy low and sell high.

Sorry for the long explanation, but I believe it was necessary in order to truly answer your question/concern.

David, please feel free to chime in and let us know if my explanation makes sense.

Thanks,


Charles