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ABC & XYZ Co: Financial Analysis of shares and company mergers

Expected Earning Number of Shares Market Price Per Share Tax Rate
ABC Company $5,000,000 1,000,000 $100 50%
XYZ Company $3,000,000 500,000 $ 60 50%

The ABC Company wishes to acquire the XYZ Company. If the merger were effected through an exchange of shares, ABC would be willing to pay a 25% premium for the XYZ shares. If done for cash, the terms would have to be just as favourable to the XYZ shareholders. In order to obtain the cash, ABC would have to issue new shares in the market.

a. Compute the share exchange ratio and the combined expected earnings per share for ABC under an exchange of shares.
b. Assume that all XYZ shareholders have held their shares for more than one year, have a 28% marginal capital gains tax rate, and paid an average of $14 for their shares. What cash price would have to be offered to be just as attractive as the terms in part (a)?

Assume the exchange of ABC shares for XYZ shares as outlined above:

c. What is the share exchange rate?
d. Compare the earnings per XYZ share before and after the merger. Compare the earnings per ABC share before and after the merger. On this basis alone, which merger group fared better? Why?
e. Why do you imagine that ABC commanded a higher P/E ratio than XYZ? What should be the change in P/E ratio resulting from the merger? Does this conflict with your previous result? Why?

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