###### Value of a Bond and its Credit Spread

The arbitrage-free framework is applied for credit analysis of a risky bond, assuming... **Read More**

* Bootstrapping earnings* (or bootstrap effect) occurs when a company’s earnings increase because of the merger transaction instead of the resulting economic benefit of the merger.

Axon Ltd. has identified an opportunity to merge with Symbian systems to form A&S systems, and the details of both companies are as follows.

$$\small{\begin{array}{l|c|c|c} {}& \textbf{Axon} & \textbf{Symbian} & \textbf{A&S} \\ \hline\text{Stock price} & \$200 & \$100 & \\ \hline\text{EPS} & \$4 & \$4 & \$ 4.80 \\ \hline\text{P/E} & 50 & 25 & \\ \hline\text{Total shares outstanding} & 200,000 & 100,000 & 250,000 \\ \hline\text{Total earnings} & \$ 800,000 & \$ 400,000 & \$ 1,200,000 \\ \hline\text{Market value of equity} & \$ 40,000,000 & \$ 10,000,000 & {}\\ \end{array}}$$

At a stock price of $200, Axon can issue \(50,000= \bigg(\frac{$10,000,000}{$200}\bigg)\) of its shares and use the proceeds to buy Symbian.

The total shares outstanding for the merged company A&S are \(200,000+50,000=250,000 \text{ shares}\).

The post-merger combined earnings are \(\$800,000+\$400,000=\$1,200,000\).

$$\text{A&S EPS after the merger}=\frac{$1,200,000}{250,000 \text{ shares}}=$4.80/\text{share}$$

The EPS of A&S is $0.80 more than that of the acquirer Axon. If the stock price after the merger remains $200, the P/E ratio would be 20.80. If the acquirer bootstraps earnings to $4.80 per share, the share price will increase to $240 if the investors apply the acquirer’s pre-merger P/E of 50 times earnings \(($4.80×50 = $240)\); however, such share price increases are not expected when there are no expected gains from synergy or other factors.

For bootstrapping to work, the acquirer’s P/E ratio must be higher than the target’s P/E. Although the market recognizes the bootstrapping effect and P/Es adjust accordingly after the merger, sometimes bootstrapping pays off for managers in the short run.

## Question

Bolton manufacturing is planning to merge with Ramsey Chemicals, an industrial chemical supplier, to lock in crucial chemical suppliers and lower manufacturing costs. The post-merger company is called Bolts, and the details of the companies are as follows:

$$\small{\begin{array}{l|c|c} {}& \textbf{Bolton} & \textbf{Ramsey} \\ \hline\text{Stock price} & \$150 & \$ 75 \\ \hline\text{EPS} & \$3 & \$ 2 \\ \hline

\text{P/E} & 50 & 37.5 \\ \hline\text{Total shares outstanding} & 200,000 & 150,000 \\ \hline\text{Total earnings} & \$ 600,000 & \$ 300,000 \\ \hline\text{Market value of equity} & \$ 12,000,000 & \$ 4,500,000\\ \end{array}}$$Bolts’ EPS is

closest to:

- $3.
- $3.90.
- $195.
## Solution

The correct answer is B.$$\small{\begin{array}{l|c|c|c} {}& \textbf{Bolton} & \textbf{Ramsey} & \textbf{Bolts} \\ \hline\text{Stock price} & \$150 & \$75 & \\ \hline\text{EPS}^{2} & \$3 & \$2 & \$ 3.90 \\ \hline\text{P/E} & 50 & 37.5 & \\ \hline\text{Total shares outstanding}^{1} & 200,000 & 150,000 & 230,000 \\ \hline\text{Total earnings} & \$600,000 & \$300,000 & \$900,000 \\ \hline\text{The market value of equity} & \$12,000,000 & \$4,500,000 & \\ \end{array}}$$

With a stock price of $150, Bolton can issue 30,000 shares and use the proceeds to buy Ramsey.

$$\text{Number of shares required}=\frac{$4,500,000}{$150}=30,000$$

Total shares outstanding

^{1}for Bolts = Bolton’s total outstanding shares plus the number of shares needed to buy Ramsey.$$\text{Total shares outstanding}^{1}\ \text{for bolts}=200,000+30,000=230,000$$

\(\text{EPS}^{2}\) for Bolts = Bolts’ total earnings divided by Bolts total shares outstanding.

$$\text{EPS}^{2}\ \text{for Bolts}=\frac{$900,000}{230,000}=$3.90$$

A is incorrect.This is Bolton’s EPS before the merger.

C is incorrect.$195 is Bolts’ share price when Bolton bootstrap earnings to $3.90 per share, leading to increased share price \(($3.90×50)\).

Reading 18: Mergers and Acquisitions

*LOS 18 (c) Explain bootstrapping of earnings per share (EPS) and calculate a company’s post-merger EPS.*