Question

Firm A has a value of $500 million and Firm B has a value of $300 million. Firm A has 1000 shares outstanding, and Firm B has 800 shares outstanding. Suppose that the merger would increase cash flows of the combined firm by $5 million in perpetuity. Assuming the cost of capital for the new firm is 5%.

If Firm A purchases Firm B for $330 million, how much do Firm B's shareholders gain from this merger?

	A.	$30 million
	B.	$70 million
	C.	$20 million
	D.	$15 million
	E.	None of the above

2.

VFIC Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing. The pilot production and test marketing phase will cost $100,000 and last for one year. The management team believes that there is a 30% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike. If the test-marketing phase is successful, then VFIC will invest $2 million to build a plant immediately that will generate expected annual after-tax cash flows of $300,000 in perpetuity starting in year two. If the test marketing is not successful, VFIC can still go ahead and build the new plant, but the expected annual after-tax cash flows would be only $150,000 in perpetuity starting in year two. VFIC's cost of capital is 10%.

Suppose that VFIC has the option to sell the prototype mountain bike at the end of the first year for $50,000. The NPV of the VFIC Mountain Bike Project is around:

	A.	$90,909
	B.	$204,545
	C.	$455,000
	D.	-$45,455
	E.	None of the above

Answer 1

1. Gain from the merger = Value received from Firm A - Value of Firm B Before merger

Gain from the merger = 330 M - 300 M

Gain from the merger = 30 M Option A

2. NPV = (probability of success * [(After tax cash flow/Required rate) - Investment] + probability of not success * [(After tax cash flow/Required rate) - Investment]) / (1 + Required rate)

NPV = (0.30 * [(300000/10%) - 2000000] + 0.70 * [(150000/10%) - 200000]) / (1 + 10%)

NPV = (0.30 * 1000000 + 0.70 * -500000 / (1 + 10%)

NPV = (-50000 / (1 + 10%)

NPV = -$45455 Option D

* Marketing cost is a sunk costs thus ignored