 # Bootstrapping Earnings

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.

#### Example: Bootstrapping Earnings

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: 1.$3.
2. $3.90. 3.$195.

#### Solution

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

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 outstanding1 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 $$(3.90×50)$$.

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

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