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When bootstrapping, the acquiring firm purchases:
A)
slow growth firms with low price-to-earnings (P/E) ratios.
B)
high growth firms with high price-to-earnings (P/E) ratios.
C)
high growth firms with low price-to-earnings (P/E) ratios.



Bootstrapping involves a high growth, high P/E ratio firm purchasing slow growth firms with low P/E ratios. The low P/E implies that the acquiring firm can purchase the firm “cheap” since its stock exhibits a higher price for a given level of earnings. The end result is that the earnings of the two firms are added together, while the exchange of high P/E company’s shares are made at a less than 1 to 1 ratio for the low P/E company shares. Thus, earnings per share will increase due to the lower total number of shares outstanding.

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Riley Industries is a manufacturer of after-market automobile parts that are distributed and sold throughout the United States. The company possesses significant market share, with last year's sales exceeding $450 million. Gross sales of Riley Industries, plus two other comparable-sized competitors, represent roughly 60% of parts sold to the major auto parts retailers in the U.S. last year. Of the remaining 40% of sales, market share is highly fragmented, with no single supplier exceeding 5% of the market's overall market sales. Riley Industries' management has proposed a merger with Durable Parts, a small manufacturer with sales of $50 million per year. The merger with Durable Parts would give Riley Industries an additional manufacturing facility in a central region of the country where Riley Industries does not currently have production operations. Previously, Riley Industries' management had considered the possibility of constructing a new facility in that area, and Durable Part's relatively new facility can provide the additional capacity that Riley Industries is seeking in order to meet increasing demand.
The proposed merger is structured as a stock purchase, in which the shareholders of Durable Parts receive shares of Riley Industries' common stock. The proposed exchange ratio is 1:5, meaning that for every 5 Durable Parts shares owned, shareholders will receive one share of Riley Industries.
<P > [td=1,1,111]Riley IndustriesDurable PartsRiley — Post Merger
Stock Price$50.00$10.00$50.00
EPS$3.50$2.25<P > [/td]
P/E Ratio14.294.44<P > [/td]
Total shares o/s9,000,0003,000,000<P >

Neither the management nor the shareholders of Durable Parts had anticipated being the target of a merger transaction. Several members of the board have expressed their desire to remain an independent entity, and have proposed seeking a friendly third party that would be willing to purchase a minority stake in the company without buying controlling interest. This would block Riley Industries from gaining enough shareholder approval to purchase the entire operation. The board acknowledges that there is some additional risk involved in the pursuit of this strategy, but is not aware of any other viable options that would allow Durable Parts to remain an independent company.
Additionally, the same members of Durable Part's board of directors have instructed the company's accountants to estimate the Herfindahl-Hirschman Index (HHI) for the industry, both pre- and post-merger. They estimate the pre-merger HHI is 975, while the post-merger HHI is 990. They believe that the increase in post-merger HHI indicates that Riley Industries should not continue to pursue the merger because of a likely antitrust challenge.The impetus behind the merger of Riley Industries with a Durable Parts, a smaller competitor, is to provide Riley with the means to increase its own production capacity. This type of merger is commonly called a:
A)
horizontal merger.
B)
consolidation.
C)
synergistic merger.



In a horizontal merger, both entities operate in the same or similar industries, and the operations of the combined company would be similar to the two, pre-merger companies. (Study Session 9, LOS 32.a)

Companies can utilize a strategy whereby a high P/E firm acquires a low P/E firm in exchange for stock is commonly called:
A)
vertical merger.
B)
horizontal merger.
C)
bootstrapping.



Bootstrapping combines the earnings from two companies after a merger so that the result of the merger is an increase in earnings per share of the acquirer, even though no real economic gains have been achieved. (Study Session 9, LOS 32.c)

Given the above information, the post-merger EPS of Riley Industries is closest to:
A)
$3.04.
B)
$3.98.
C)
$3.19.



Using the 1:5 exchange ratio, Riley will issue 600,000 shares (3,000,000 / 5). The 1:5 conversion ratio is intuitive if you note that Riley’s pre-merger stock price is $50 per share and Durable’s market cap is $30,000,000 (3,000,000 x $10). Riley issues 600,000 new shares to generate the funds to purchase Durable ($30,000,000 market cap / $50 = 600,000 shares). Thus, the total number of shares outstanding after the merger would be 9,600,000 shares. The total post-merger income ([$3.50 / share × 9,000,000] + [$2.25 / share × 3,000,000]) = $38,250,000. Therefore the post-merger EPS is $38,250,000 / 9,600,000 shares = $3.98.
The result of bootstrapping is the creation of the appearance of growth in earnings. The acquiring firm is essentially exchanging high P/E shares for low P/E shares. The combined entity has fewer total shares outstanding than the two separate entities, but the same earnings, resulting in a higher EPS. (Study Session 9, LOS 32.c)


Riley Industries will give the owners of Durable Parts shares of Riley stock in exchange for the outstanding shares of Durable. Which of the following statements regarding a stock purchase is most accurate?
A)
With a stock purchase, it is the shareholders of the target company that directly receive compensation, not the company itself.
B)
The shareholders of the target company will not bear any tax consequences associated with the stock purchase; any taxes due are the financial obligation of the acquirer.
C)
Most stock purchases do not involve purchasing the entire company, but rather a portion of the firm or a specific operating division.



Since the shareholders are the owners of the target company, they receive the compensation from any acquisition, whether by cash or securities. Typically, a majority of the shareholders must approve the transaction, and sometimes even more than a majority is required. (Study Session 9, LOS 32.e)

The strategy proposed by Durable’s management of seeking a friendly third party to purchase a minority stake in its firm in order to block Riley’s proposed merger with Durable is most commonly referred to as a:
A)
white squire defense.
B)
white knight defense.
C)
crown jewel defense.





A white squire defense is similar in nature to a white knight defense. A white knight is a friendly third party that will acquire all of the assets of a target company, while a white squire will only buy a minority stake in the target. The white squire will buy enough to thwart a hostile takeover, but not enough to gain control of the target. (Study Session 9, LOS 32.f)

The estimated pre- and post-merger HHI for the industry are 975 and 990 respectively. Which of the following statements regarding these HHI calculations is most accurate?
A)
Regulators consider a post-merger HHI value greater than 1,800 to be indicative of a “moderately concentrated” industry.
B)
Any merger that results in a change in HHI between pre- and post-merger HHI that is greater than 100 is likely to be challenged.
C)
A post-merger HHI of less than 1,000 is indicative of a competitive industry and an antitrust challenge is unlikely.



The HHI is calculated as the sum of the squared market shares for all firms in an industry. A post-merger HHI that is less than 1,000 indicates an industry that is not concentrated, and an antitrust challenge is unlikely. (Study Session 9, LOS 32.g)

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In general, in order for earnings per share bootstrapping to occur, which of the following is most accurate?
A)
The P/E ratio of the target must be greater than that for the acquirer.
B)
The net income of the target must be greater than that for the acquirer.
C)
The price-to-earnings (P/E) ratio of the acquirer must be greater than that for the target.



In order for earnings per share bootstrapping to occur, the P/E ratio of the acquirer must be greater than that for the target.

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Which of the following statements regarding bootstrapping and its effect on earnings per share (EPS) is CORRECT? Bootstrapping:
A)
increases current EPS and decreases future EPS.
B)
increases current EPS and increases future EPS.
C)
decreases current EPS and increases future EPS.



Bootstrapping increases current EPS at the expense of lower growth prospects and lower future EPS.

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The Larson Trust holds a broad portfolio of firms. One of the Trust’s holdings, Music World, is growing at roughly the same, or slightly slower rate as the overall economy. The Trust is considering selling the firm. What stage of the industry lifecycle is Music World most likely in, and which method of selling the firm is most probable?
A)
Stabilization phase, divestiture.
B)
Decline phase, divestiture.
C)
Stabilization phase, equity carve-out.



Music World appears to be in the stabilization phase, as it is growing at approximately the same rate as the overall economy. If it were in the decline phase, growth would be negative. Divestiture, most likely to a firm in a similar line of business, is more likely than an equity carve-out. A divestiture would allow the buyer to consolidate market share. An equity carve-out would involve a public offering of shares with only marginal attractiveness as a stand-alone enterprise

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Conglomerate mergers are least likely for companies in which stages of the industry lifecycle?
A)
Mature Growth, Stabilization.
B)
Stabilization, Decline.
C)
Pioneer/Development, Rapid Growth.



Conglomerate mergers are least likely for firms in the mature growth and stabilization stages of the industry lifecycle. In these stages, industry growth is slowing, and they are more likely to be seeking horizontal mergers to enhance economies of scale.

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When an industry has reached the stabilization stage, the most common type of merger is:
A)
vertical.
B)
conglomerate.
C)
horizontal.



In the stabilization stage, companies typically seek mergers to improve economies of scale. Horizontal mergers are the most common as stronger companies acquire weaker companies to expand market share and reduce costs.

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Firms are most likely to seek mergers in order to gain access to capital during which industry lifecycle stages?
A)
Pioneer/Development and Rapid Growth.
B)
Pioneer/Development and Decline.
C)
Rapid Growth and Mature Growth.


The industry lifestyle stages during which firms often merge to gain access to additional capital are the pioneer/development and rapid growth stages.

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What form of acquisition is most likely to be associated with a hostile takeover, and which defense is most likely to be employed by the target’s management to fend off the unwanted offer?
A)
Stock purchase and poison pill.
B)
Asset purchase and greenmail.
C)
Stock purchase and greenmail.



A stock purchase is more likely when the target is hostile to the proposed merger because an asset purchase would ordinarily involve negotiations between two mutually agreeable parties. A poison pill is a pre-offer defense. If one were in place, it would be employed, but if it existed it is far less likely that a hostile merger would ever be proposed. Hence, greenmail is a more likely defense mechanism because it is a post-offer takeover defense.

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When a merger occurs, the two main forms for the acquisition are:
A)
asset purchase or liability assumption.
B)
asset purchase or subsidiary carve-out.
C)
stock purchase or asset purchase.



The two main forms of acquisition are stock purchase—the acquirer purchases all of the target’s stock—or asset purchase—the acquirer agrees to purchase all of the target’s assets.

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