Impact Of Issuing Debt On Shareholders - Essay Example

A. IMPACT OF ISSUING DEBT ON SHAREHOLDERS The directors hold different views of the impact of issuing debt on the firm’s shareholders. Some had heard about “homemade leverage” and would not be convinced. This is Modigliani and Miller (1958)’s famous MM proposition I, which states that capital structure decision is irrelevant, i.e., the value of the levered firm is equal to the value of the unlevered firm. Otherwise, investors can invest in the firm with the lower value by creating “homemade leverage”. However, the directors should be aware that this proposition was developed with a number of assumptions, some of which are unrealistic in the real world. As some of the directors felt, the tax shelter offered by debt is never considered in MM’s proposition I, neither is bankruptcy costs. Fortunately, Copeland and Weston (1988) show that even when the assumptions are relaxed, Modigliani and Miller (1958)’s theory of irrelevance of capital structure still holds in most cases. The two assumptions that are not robust in the real world are namely, (1) There are no costs to bankruptcy; and (2) There are no taxes. Copeland and Weston (1988) demonstrate that, in a world with personal and corporate taxes, capital structure decision is relevant due to the tax shelters afforded by interest expenses for the firm and the difference in personal tax rates for holding shares and bonds. The gain from leverage, G, is: where Tc = corporate tax rate TpS = rate on income received from holding shares TpB = rate on income from holding bonds B = market value of the bonds The corporate tax rate is 40%. There is a quirk in the U.K. tax system that favours investment in shares rather than bonds, particularly at higher income tax bands. The personal income tax rates on dividends and bond interests are as follows: Table A.1 Personal Income Tax Rates 2005-2006 Income Tax Band Rate on Income from Holding Bonds Rate on Dividend Income Capital Gains Tax Starting Rate: 1 to 2,090 10% 10% 10% Basic Rate: 2,091 to 32,400 20% 10% 20% Higher Rate: 32,401 and above 40% 32.5% 40% Source: Directgov, 2006 Hence, from the table above, it can be seen that if Tyneside Electronics Plc were to pay no dividends, then the personal tax rates on income from bonds and shares would be the same, and the gain from leverage, G, would be: = 0.4 X 500,000,000 = 200,000,000 However, if Tyneside Electronics Plc were to pay dividends and assuming no capital gains, then the gain from leverage under different levels of income tax band would be: Table A.2 Gain from Leverage across Income Tax Bands of Investors Income Tax Band Starting Rate: 1 to 2,090 Basic Rate: 2,091 to 32,400 Higher Rate: 32,401 and above Tax Rate on Dividend Income 10% 10% 32.5% Tax Rate on Income from Holding Bonds 10% 20% 40% Gain from Leverage, G 200million 162.5million 162.5million As can be seen from the above calculations, the gain from leverage is the highest when the firm pays no dividend or when the investment income of the investor belongs to the income tax band taxed at the starting rate. At higher level of investment income, the tax rate on dividends is lower than that on interests from bonds, reducing the benefits of the tax shelter from holding shares. Copeland and Weston (1988) go on to demonstrate how bankruptcy costs can diminish the value of the firm. Although they were unable to determine the extent of bankruptcy costs, the literature estimates bankruptcy costs to be 1 percent to 3 percent of the market value of the firm (Altman, 1984; Warner, 1977; Wess, 1990; and White, 1983). The consensus is around 3% of the market value of the firm when bankruptcy is imminent. Hence, the bankruptcy costs as a result of issuing debt for the expansion project is estimated to be 15million (500 million X 0.03). The overall impact of issuing debt on the firm’s shareholders can be summarised in the below table: Table A.3 Gain from Leverage across Dividend Policies and Income Tax Bands of Investors Dividend Policy and Income Tax Band No Dividend Dividends, No Capital Gains Starting Rate: 1 to 2,090 Basic Rate: 2,091 to 32,400 Higher Rate: 32,401 and above Gain from Tax Shelter on Interest 200million 200million 162.5million 162.5million Bankruptcy Costs 15million 15million 15million 15million Overall Gain from Leverage 185million 185million 147.5million 147.5million B. EFFECT OF ISSUING DEBT ON KEY PROFITABLITY RATIOS Current P/E = 11.11 Current earnings per share = 135million/50million shares = 2.7 per share Current earnings = 135million If the firm were to raise all of the capital by issuing 5 year notes, the key profitability ratios of Tyneside Electronics Plc for the next 5 years under the best case scenario, in-between scenario, and worst case scenario, are shown in the tables below: Table B.1 Effect of Issuing Debt on Key Profitability Ratios: Best Case Scenario (50% Increase in Revenue Per Year) Year 1 Year 2 Year 3 Year 4 Year 5 million million million million million Sales 2250 3375 5062.5 7593.75 11390.63 COGS 1050 1050 1050 1050 1050 Gross Profit 1200 2325 4012.5 6543.75 10340.63 Interest Expense 50 50 50 50 50 Selling and Admin Expense 75 75 75 75 75 Depreciation 250 250 250 250 250 EBIT 825 1950 3637.5 6168.75 9965.625 Taxes (40%) 330 780 1455 2467.5 3986.25 Net Income 495 1170 2182.5 3701.25 5979.375 Earnings per Share 9.9 23.4 43.65 74.025 119.5875 Table B.2 Effect of Issuing Debt on Key Profitability Ratios: In-Between Scenario (30% Increase in Revenue Per Year) Year 1 Year 2 Year 3 Year 4 Year 5 million million million million million Sales 1950 2535 3295.5 4284.15 5569.395 COGS 1050 1050 1050 1050 1050 Gross Profit 900 1485 2245.5 3234.15 4519.395 Interest Expense 50 50 50 50 50 Selling and Admin Expense 75 75 75 75 75 Depreciation 250 250 250 250 250 EBIT 525 1110 1870.5 2859.15 4144.395 Taxes (40%) 210 444 748.2 1143.66 1657.758 Net Income 315 666 1122.3 1715.49 2486.637 Earnings per Share 6.3 13.32 22.446 34.3098 49.73274 Table B.3 Effect of Issuing Debt on Key Profitability Ratios: Worst Case Scenario (10% Increase in Revenue Per Year) Year 1 Year 2 Year 3 Year 4 Year 5 million million million million million Sales 1650 1815 1996.5 2196.15 2415.765 COGS 1050 1050 1050 1050 1050 Gross Profit 600 765 946.5 1146.15 1365.765 Interest Expense 50 50 50 50 50 Selling and Admin Expense 75 75 75 75 75 Depreciation 250 250 250 250 250 EBIT 225 390 571.5 771.15 990.765 Taxes (40%) 90 156 228.6 308.46 396.306 Net Income 135 234 342.9 462.69 594.459 Earnings per Share 2.7 4.68 6.858 9.2538 11.88918 From the tables above, it can be seen that even under the worst case scenario of 10% increase in revenue per year, the earnings per share will increase will remain constant for the first year and increase over fourfold by year 5. Under the best case scenario of 50% increase in revenue per year, earnings per share increase by over 3 times in year 1 and booms to 119.59 in year 5. C. EFFECT OF CHANGE IN DEBT TO EQUITY RATIO ON WEIGHTED AVERAGE COST OF CAPITAL According to Sharpe (1964), rs = rF +  (rM - rF) where rs = expected return on shares rF = risk-free rate  = beta of security rM = expected return on market Therefore, the expected return on Tyneside Electronics Plc’s shares rs is: rs = 0.04 + 1 X (0.12 – 0.04) = 0.12 where rWACC = weighted average cost of capital B = value of debt VL = value of the levered firm RB = cost of debt TC = corporate tax rate S = value of shares rS = expected return on shares = The graph below shows the effect of increasing leverage on the weighted average cost of capital for the firm. As can be seen from the graph, the value of the firm is maximised when D/E is 1 and rWACC is 0.09. However, this optimal capital structure hinges on the assumption that rs stays constant.  and rs are expected to increase as leverage increases, increasing rWACC (Modigliani and Miller, 1958). Figure C.1 Effect of Change in D/E on rWACC D. MODIGLIANI AND MILLER’S PROPOSITIONS I AND II WITH CORPORATE TAXES To illustrate Modigliani and Miller (1058)’s proposition I with corporate taxes, assume that sales increases by 50% per year. Table D.1 shows the value of the firm with leverage, while table D.2 shows the value of the unlevered firm. Table D.1 Value of the Levered Firm Year 1 Year 2 Year 3 Year 4 Year 5 million million million million million Sales 2250 3375 5062.5 7593.75 11390.63 COGS 1050 1050 1050 1050 1050 Gross Profit 1200 2325 4012.5 6543.75 10340.63 Interest Expense 50 50 50 50 50 Selling and Admin Expense 75 75 75 75 75 Depreciation 250 250 250 250 250 EBIT 825 1950 3637.5 6168.75 9965.625 Taxes (40%) 330 780 1455 2467.5 3986.25 Net Income 495 1170 2182.5 3701.25 5979.375 Interest to Bondholders 50 50 50 50 50 Value of the Firm 545 1220 2232.5 3751.25 6029.375 Table D.2 Value of the Unlevered Firm Year 1 Year 2 Year 3 Year 4 Year 5 million million million million million Sales 2250 3375 5062.5 7593.75 11390.63 COGS 1050 1050 1050 1050 1050 Gross Profit 1200 2325 4012.5 6543.75 10340.63 Interest Expense 0 0 0 0 0 Selling and Admin Expense 75 75 75 75 75 Depreciation 250 250 250 250 250 EBIT 875 2000 3687.5 6218.75 10015.63 Taxes (40%) 350 800 1475 2487.5 4006.25 Net Income 525 1200 2212.5 3731.25 6009.375 Interest to Bondholders 0 0 0 0 0 Value of the Firm 525 1200 2212.5 3731.25 6009.375 As can be seen from the tables above, the value of the levered firm is 20million more than that of the unlevered firm. This is exactly the value of the tax shelter from interest (0.4 X 10% X 500million). Under Modigliani and Miller (1958)’s proposition II with no corporate taxes, where r0 = expected return on shares of unlevered firm All other terms are as defined above In section C, we calculate r0 to be 12%. Therefore, assuming the firm were to raise all of the capital by issuing 5 year notes, = 0.128 Hence, from the above calculations, we see that the expected return on shares of the levered firm is higher than that of the unlevered firm by 0.8%. The higher expected return on shares of the levered firm is due to the higher risks associated with debt. E. RESIDUAL DIVIDEND POLICY The worst case scenario of 10% growth in revenue is used to calculate the dividend per share Tyneside Electronics can afford to pay if it decides to go along with the expansion project. Tables E.1 to E.5 show the dividend per share under different capital structure scenarios across all 5 years. Table E.1 Dividend Per Share in Year 1 Across Different Capital Structure Scenario Target Capital Structure S/(S+B) 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 Target S 250 500 750 1000 1250 1500 1750 2000 2250 2500 Interest 225 200 175 150 125 100 75 50 25 0 Tax Shelter from Interest 90 80 70 60 50 40 30 20 10 0 Net Income 30 45 60 75 90 105 120 135 150 165 Current S 1500 1500 1500 1500 1500 1500 1500 1500 1500 1500 Residual Dividends 1280 1045 810 575 340 105 -130 -365 -600 -835 Residual Dividends Per Share 25.6 20.9 16.2 11.5 6.8 2.1 -2.6 -7.3 -12 -16.7 Table E.2 Dividend Per Share in Year 2 Across Different Capital Structure Scenario Target Capital Structure S/(S+B) 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 Target S 250 500 750 1000 1250 1500 1750 2000 2250 2500 Interest 225 200 175 150 125 100 75 50 25 0 Tax Shelter from Interest 90 80 70 60 50 40 30 20 10 0 Net Income 129 144 159 174 189 204 219 234 249 264 Current S 1500 1500 1500 1500 1500 1500 1500 1500 1500 1500 Residual Dividends 1379 1144 909 674 439 204 -31 -266 -501 -736 Residual Dividends Per Share 27.58 22.88 18.18 13.48 8.78 4.08 -0.62 -5.32 -10.02 -14.72 Table E.3 Dividend Per Share in Year 3 Across Different Capital Structure Scenario Target Capital Structure S/(S+B) 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 Target S 250 500 750 1000 1250 1500 1750 2000 2250 2500 Interest 225 200 175 150 125 100 75 50 25 0 Tax Shelter from Interest 90 80 70 60 50 40 30 20 10 0 Net Income 237.9 252.9 267.9 282.9 297.9 312.9 327.9 342.9 357.9 372.9 Current S 1500 1500 1500 1500 1500 1500 1500 1500 1500 1500 Residual Dividends 1487.9 1252.9 1017.9 782.9 547.9 312.9 77.9 -157.1 -392.1 -627.1 Residual Dividends Per Share 29.76 25.06 20.36 15.66 10.96 6.26 1.56 -3.14 -7.84 -12.54 Table E.4 Dividend Per Share in Year 4 Across Different Capital Structure Scenario Target Capital Structure S/(S+B) 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 Target S 250 500 750 1000 1250 1500 1750 2000 2250 2500 Interest 225 200 175 150 125 100 75 50 25 0 Tax Shelter from Interest 90 80 70 60 50 40 30 20 10 0 Net Income 357.69 372.69 387.69 402.69 417.69 432.69 447.69 462.69 477.69 492.69 Current S 1500 1500 1500 1500 1500 1500 1500 1500 1500 1500 Residual Dividends 1607.69 1372.69 1137.69 902.69 667.69 432.69 197.69 -37.31 -272.31 -507.31 Residual Dividends Per Share 32.15 27.45 22.75 18.05 13.35 8.65 3.95 -0.75 -5.45 -10.15 Table E.5 Dividend Per Share in Year 5 Across Different Capital Structure Scenario Target Capital Structure S/(S+B) 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 Target S 250 500 750 1000 1250 1500 1750 2000 2250 2500 Interest 225 200 175 150 125 100 75 50 25 0 Tax Shelter from Interest 90 80 70 60 50 40 30 20 10 0 Net Income 489.46 504.46 519.46 534.46 549.46 564.46 579.46 594.46 609.46 624.46 Current S 1500 1500 1500 1500 1500 1500 1500 1500 1500 1500 Residual Dividends 1739.46 1504.46 1269.46 1034.46 799.46 564.46 329.46 94.46 -140.54 -375.54 Residual Dividends Per Share 34.79 30.09 25.39 20.69 15.99 11.29 6.59 1.89 -2.81 -7.51 As can be seen from the above tables, the higher the leverage for a certain year, the lower the amount of retained earnings needed to be plough back into firm to maintain the capital structure, the more that can be distributed as residual dividends. Also, towards the end of the project at year 5, the higher the revenue, and the more than can be distributed as residual dividends. F. STOPPING OF PAYMENTS OF DIVIDENDS As Jane Long correctly argues, the value of the firm is unaffected by dividend policy. This is Miller and Modigliani (1961)’s argument. However, their model assumes a world without taxes or transaction costs. In the real world, as can be seen from Table A.1, in U.K, dividends are taxed at a lower rate than capital gain, favouring high dividend payout. Let us analyse the clientele effect, as suggested by Ray Bent. The firm’s main clientele are individuals, holding 57% of its shares. This group of individuals would prefer dividends, as personal income tax rates on dividends are lower than that on capital gains. Next come the pension funds accounting for 24% of the firms’ clientele. As pension funds are exempted from tax, this group faces no tax consequences. They are like to favour dividends. In view of the clientele effect, Joe Lomax is right to remark that shareholders “may vote with their feet” if the firm does not pay any dividends. More than half of the firm’s shares are held by individuals. This group of “widows and orphans” would desire current income. Though they could have sold off their shares with low dividend policy, transaction costs are incurred for this group of individuals. Although, a firm’s risk is not affected by its dividend policy, Gordon (1961), in his development of stock price valuation, argues that individuals view distant dividend payments as risky and would discount them at a higher rate than current dividends. Hence, the stopping of payments of dividends will lead to a lower firm value. Furthermore, the firm has diffused share ownership, as can be seen from Table 3 in the case study. This can increase agency costs arising from conflicts between shareholders and management. Rozeff (1986) and Hansen et. al. (1994) suggest that high dividend payments is a way to reduce agency costs. Empirical studies (Ahroney and Swary, 1980; Asquith and Mullins, 1983; Charest, 1978; Pettit, 1972) have also found significant increases in share price on the day the dividend was announced. Bhattacharya (1979) develops a tax-based signaling cost structure that concludes that dividend functions as a signal of expected cash flows. His single-period model states that because there is a cost in distributing dividend and is costly to finance any shortfall when a company still choose to distribute additional dividend, it is truthfully signaling to the investor that an increase in the firm’s value is to be anticipated. If insiders are not “telling the truth”, shareholders will find out and since the wrong signal incur cost and the subsequent market value of the firm will decrease accordingly. Therefore, Bob Knowles is right in saying that the firm has “to be able to continue supporting whatever dividend payout ratio” it goes with, “or else the negative information backlash could come back to haunt” the firm. In conclusion, due to the tax benefits and transaction costs of the firm’s main clientele, as well as the reduction of agency costs, it should pay out dividends. However, due to the signaling effects, the firm should only pay what it is able to afford. G. RESIDUAL DIVIDEND POLICY ACCOMPANIED BY A REPURCHASE OF STOCK In the first place, a residual dividend policy is adopted with the purpose of maintaining a certain D/E ratio. A repurchase of stock will reduce equity and causes imbalance to the D/E ratio. This totally defeats the purpose of the residual dividend policy. H. ACQUISITION OF PRODUCTOS REUNIDOS Synergy that results in revenue enhancement, cost reduction, lower taxes, and lower cost of capital could be obtained from the acquisition of Productos Reunidos (Jaffe et. al., 1996). Revenue enhancement could be achieved from marketing gains. The members of the M&A committee felt that marketing costs could be significantly reduced due to Tyneside Electronic’s marketing expertise. Cost reduction could be achieved as production costs could be significantly reduced due to Tyneside Electronic’s technical expertise. Also, since Productos Reunidos is operating in a different industrial and geographical sector, diversification benefits could be gained. After acquisition, the bankruptcy costs of the new entity would be lower than the sum of the original two entities due to diversification benefits. The reduced bankruptcy costs increase the debt capacity and lower taxes. Lower cost of capital is achieved because the cost of raising debt and equity is lower for larger issues than for small issues. Most importantly, the acquisition is a positive net present value project, as shown by the below calculation: Price per share = 8 X 1.2 = 9.6 Present market price of Productos Reunidos = 9.6 per share X 50 million shares = 480 million Present value of incremental cash flow from the acquisition = 150million/0.04 = 3,750million Net present value of the acquisition = 3,750 million – 480 million = 3.270 million Though there are benefits to be obtained from taking over Productos Reunidos, there are some reasons against the acquisition too. Arising from the diversification, earnings may be less varied. Less volatility decreases the probability of financial distress. The bondholders benefit at the expense of the shareholders. Shareholders may or may not benefit from the increase in value mentioned in the above paragraph, depending on the loss of value due to less volatility. Also, one of the board member was wondering whether by acquiring Productos Reunidos could the “relative PE magic” be realised. The relative PE magic arises when the market is fooled into thinking that the increase in earnings is a result of true growth in earnings. They are willing to pay the same price per dollar of earning. As a result, price per share increases. This should not be a reason for taking over Productos Reunidos because efficient market will work its wonders and PE will fall. Lastly, the benefit of diversification to debt capacity is increased in the above paragraph. This should be the reason that diversification should be used as a benefit of acquisition, rather than the elimination of risks from operation in different industrial sectors that the M&A committee felt. Shareholders can always diversify at lower costs by adjusting their personal portfolios. I. THE RELATIVE PE GAME Table I.1 Financial Positions of Tyneside Electronics and Productos Reunidos New Company after the Acquisition Tyneside Electronics Productos Reunidos The Market The Market before Acquisition before Acquisition is "Smart" is "Fooled" Earnings per share 2.7 1.2 3.12 3.12 Price per share 11.11 9.6 11.11 12.84 PE ratio 4.11 8 3.56 4.11 Number of shares (million) 50 50 62.5 62.5 Total earnings (million) 135 60 195 195 Total value (million) 555.5 480 694.38 802.39 If the combined net income of the two firms is the sum of their net incomes prior to the completion of the deal, then there is no true growth and additional value. Please refer to table A.1. The total earnings is equal to the sum of the earnings of the two firms prior to the completion of the deal. If the market is smart, it will recognise that there is no true growth and additional value and willing to pay the same price per share. As a result, the PE will drop since earnings per share has increased. However, if the market is fooled into thinking that the additional earnings of 60 million is true growth, then they are willing to pay the same price per dollar of earning. As earnings per share has increased, they are willing to pay a higher price per share. This is the “relative PE game”. However, this magic may not last long as market efficiency will work its wonders and price will ultimately fall. J. MAXIMUM OFFER PRICE FOR PRODUCTOS REUNIDOS Assuming that the M&A committee has no doubt about the estimation that the incremental net cash flows of the combined company is at least 15million per year for the foreseeable future, then this incremental net cash flows can be viewed as a perpetuity discounted at the risk-free rate of 4%. Therefore, Present value of incremental cash flow from the acquisition = 150million/0.04 = 3,750million Hence, the maximum offer price that Tyneside Electronics would be justified in making for Productos Reunidos is 3,750million. K. ACQUISITION’S PAYMENT MECHANISM Whether cash or stock should be used as the acquisition’s payment mechanism depends on a number of factors, including acquiring firm’s valuation, taxes, and whether the acquiring firm wants the selling firm to share in the acquisition’s success or failure (Jaffee, 1996). The firm would have to calculate its value. It is currently trading at 15 per share. If the price of15 per share is undervalued compared to its fair value – which is likely since the price of the firm has plummeted along with the market downturn, then using stock as the payment mechanism is more favourable. Moreover, in the United Kingdom, capital gains tax from receiving cash would be taxed at a higher rate than that on dividends for the selling firm. From a tax viewpoint, using stock as the payment mechanism is more favourable. The above discussion suggests the stock is the preferred payment mechanism for the acquisition for Tyneside Electronics. However, it also has to consider if it wants the shareholders of Productos Reunidos to share in its gains or losses. Issuing shares to the shareholders of Productos Reunidos implies the sharing of the post acquisition gains or losses. Hence, if the merger and acquisition committee of Tyneside Electronics is confident of a successful acquisition, it should issue cash. Otherwise, it should issue stock. L. SHARE PRICE OF TYNESIDE ELECTRONICS The academic literature cannot help in answering whether the share price of Tyneside Electronics is expected to be affected by the decision to bid for Productos Reunidos. Previous empirical studies provide inconclusive evidence. Jensen and Ruback (1983) summarise the results of numerous studies that research into the effects of mergers and tender offers on stock prices. They find that stock price experiences an abnormal increase by 4% in tender offers and there is no abnormal return in mergers. However, Asquith (1983) finds that shareholders of acquiring firms in successful mergers experienced significant abnormal losses after the announcement of the merger. One possible explanation is that managers of acquiring firms may have hubris and tend to overestimate the gains from acquisition (Roll, 1986). Another possible explanation is that since the size of the acquiring firm is typically larger than that of the selling firm, the gain in terms of percentage is relatively smaller for the acquiring firm (Jaffe et. al., 1996). Also, perhaps managers are only interested in building empires rather than increasing the value for shareholders when deciding to embark on acquisition (Jaffe et. al., 1996). The last explanation is the difficulty in measuring the returns to shareholders. Malatesta (1983) and Schipper and Thompson (1983) show that many of the gains to the stockholders of acquiring firms are realised when acquisition programs begin. The incremental effect of each acquisition on stock price may be very small, because the stock price at commencement reflects the expected gains from future acquisitions. M. DIVERSIFICATION BENEFIT As discussed in section H, the main benefit of diversification is the reduction in expected bankruptcy costs and the increase in debt capacity, leading to higher tax shelter. Another benefit of diversification is the elimination of risks from operating in different in geographical and industrial sectors. However, a caveat is that shareholders can achieve diversification at lower costs by adjusting their personal portfolios. Moreover, the benefit of diversification is achieved only through the elimination of unsystematic risks, not systematic risks. It should be noted that Productos Reunidos has a well-diversified customer base. Unsystematic risks would not be diversified by acquiring a firm that is well diversified. Unsystematic risks can only be diversified if the beta of Productos Reunidos has negative correlation or little correlation to that of Tyneside Electronics. Therefore, elimination of risks as a benefit of diversification is doubtful. N. CONCLUSION The internal rate of return of the expansion project is expected to far outperform the company’s hurdle rate. The acquisition of Productos Reunidos is also a positive net present value project. However, empirical evidence suggests that market value of the acquiring firm experiences little if any gain after acquisition, and in some cases even losses. Also, the reasons cited by the management and the merger and acquisition committee for acquisition, namely, diversification and PE magic, are wrong. 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