Los Pollos Inc.'s shares trade at $30, and the company has 100 million shares outstanding. Hermanos Ltd.'s shares trade at $20, and the firm has 30 million shares outstanding. The two companies are fully equity financed. The free cash-flows for Los Pollos Inc. are expected to be $300 million next year, while Hermanos Ltd. predicts its free cash-flows to be $72 million next year. Both companies think that the level of cash-flows will stay constant thereafter (forever). Los Pollos Inc. plans to acquire Hermanos Ltd. Assume that there are no other informational effects other than the ones described in the text. The market risk premium is 7% and the risk- free rate is 3% in this economy. 

i. Compute the unlevered (asset) Beta and the unlevered cost of capital of the combined firm assuming no synergies are created in the deal. (3 marks) The manager of Los Pollos Inc. is convinced that the acquisition will generate economies of scope. These savings amount to an additional free cash-flow of $30 million starting next year, which will subsequently occur annually and remain constant. 

ii. Compute the present value of the synergies and the value of the combined firm. Use the unlevered cost of capital calculated in (i) as the discount rate for the synergies. (3 marks) 

iii. What is the maximum percentage premium that Los Pollos Inc. could pay in a cash transaction without losing money on the acquisition? If, instead, the acquisition took place via a stock-swap transaction, what is the highest exchange ratio Los Pollos could offer? (4 marks) You are a senior analyst at a hedge fund specialising in merger arbitrage. A version of the investment strategy trades target shares after a merger announcement and closes the position once the outcome of a merger is certain. Let's implement this strategy. Assume that you can both take long and short positions in stocks.

iv. Suppose that Los Pollos and Hermanos agree to a cash offer at $27 per share. Following the announcement, Hermanos’ share price jumps to $26.3. What is the market-implied probability of the merger failing (e.g., the regulator may not approve the deal)? (3 marks) 

v. Your team of SSE interns independently estimated the probability of the merger failing. You trust your interns to know better than the market. For which range of possible SSE- intern-estimated failure probabilities would you buy Hermanos' shares after observing the share price jump to $26.3 after the announcement? What would be the maximum profit per share traded? For which range of possible SSE-intern-estimated failure probabilities would you (short) sell Hermanos' shares after observing the share price jump to $26.3 after the announcement? What would be the maximum profit per share traded? (6 marks) 

vi. Suppose instead that Los Pollos Inc. and Hermanos Ltd. agree to a stock-swap merger with an exchange ratio of 0.9. Right after the announcement of the stock-swap merger at these terms, the Hermanos Ltd. share price jumps to $26.5. What is the implied probability of the merger not going through? 

Answer rating: 100% (QA)

i The unlevered beta of the combined firm is frac300 7230 20 frac95 18 The unleve... View the full answer