Question

1- At the beginning of 2020 Alma Inc.'s management is evaluating to make an offer to buy Korte Corporation. Korte's projected operating income (EBIT) for the current year is $20 million, but Alma believes that if the two firms were merged, it could consolidate some operations, reduce Korte's expenses, and raise its EBIT to $30 million. Neither company uses any debt, and they both pay income taxes at a 25% rate. Alma has a better reputation among investors, who regard it as better managed and also less risky, so Alma's stock has a P/E ratio of 12 versus a P/E of 9 for  Korte. Since Alma's management will be running the entire enterprise after a merger, investors will value the resulting corporation based on Alma's P/E. Based on expected market values, how much synergy should the merger create, how much did the value of the firm increase?

2- The CFO of Szek, Inc. was quoted as saying, “Our company’s recent LBO has really changed things around here. We seem to be ‘watching our pennies’ like never before.” Why would an LBO result in a firm’s having to “watch its pennies”? Explain.

Answer 1

1)  

2) LBO usually involves a very high level of debt. With high levels of debt, the firm has to meet high levels of interest payments, or else they face bankruptcy risks. In order to sustain the debt payments, firms have to extremely concoius of how they spend their money. This is the reason why LBO would result in a firm watching its pennies.