29.5 A Cost to Stockholders from Reduction in Risk: The risk reduction reflected diversification. Diversification also happens in a merger.

When two firms merge, the volatility of their combined value is usually less than their volatilities as separate entities. An individual benefits from p ortfolio diversification, diversification from a merger may actually hurt the st ockholders. The reason is that the bondholders are likely to gain from the merge r because their debt is now insured by two firms, not just one. It turns out that this gain to the bondholders is at the stockholders expense. Coinsurance effect: Makes the debt less risky and more valuable than before. There is no net benefit to the firm as whole. The bondholders gain the coinsurance effect, and the stoc kholders lose the coinsurance effect. Some general conclusions are: 1. Mergers usually help bondholders .The size of the gain to bondholders de pends on the reduction in the probability of bankruptcy after the combination. T hat is, the less risky the combined firm is, the greater are the gains to bondho lders. 2. Stockholders are hurt by the amount that bondholders gain. 3. Conclusion 2 applies to mergers without synergy. In practice, much depen ds on the size of the synergy. 29.6 The NPV of a Merger Firms typically use NPV analysis when making acquisitions. The analysis is relat ively straightforward when the consideration is cash. The analysis becomes more complex when the consideration is stock. Cash: Value of firm after the acquisition = Value of combined firm-Cash paid We can also value the NPV of a merger to the acquirer: NPV of a merger to acquirer = Synergy Premium Common Stock: Value of Firm Stockholders after Merger = New Shares Issued Old Shares New Shares Issued 29.7 Friendly versus Hostile Takeovers: Mergers are generally initiated by the acquiring, not the acquired, firm. The ac quirer must decide to purchase another firm, select the tactics to effectuate th e merger, determine the highest price it is willing to pay, set an initial bid p rice, and make contact with the target firm. Often the CEO of the acquiring firm simply calls CEO of the target and proposes a merger, should the target be rece ptive, a merger eventually occurs. Of course there may be many meetings, with ne gotiations over price, terms of payment, and other parameters. The position is called toehold when the acquirer may begin by purchasing some of the target s stock in secret. Tender offer is an offer made directly to the stockho lders to buy shares at a premium above the current market price. Sometimes, once the acquirer gets working control, it proposes a merger to obtai n the few remaining shares that it does not own. The transaction is now friendly because the board of director s wills approves it. Merger of this type are often ca lled cleanup merger