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Chapter 11

Example 4

Paolo Co acquires another company and pays a price that represents a higher
P/E valuation than the current P/E of Paolo Co.

The purchase consideration is paid by issuing new Paolo Co shares. There is
no synergy arising from the takeover. Paolo Co has some debt in its capital
structure.

Which of the following would be the LEAST likely consequence of this
takeover?

A A reduction in gearing for Paolo Co

B A dilution of earnings of Paolo Co

C An increase in the share price after the takeover

D A reduction in the proportionate stake in the company of existing
Paolo Co shareholders

Solution

The answer is (C).

If Paolo Co buys another company and values the target company on a higher
P/E ratio, and if there is no synergy, there will be a reduction in the earnings
per share of Paolo Co (B). Since the acquisition is paid for by using new
shares, the gearing ratio of Paolo Co will fall (A), and existing shareholders will
own a smaller proportionate stake in the company (D). It is unlikely that the
share price will increase; in view of the reduction in earnings per share, it is
more likely that the share price will fall after the takeover.

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