You are given the following information:
In addition, the value of equity for firm A equals the value of equity for firm B, and the variance of returns for firm A and firm B are also equal. Using a risk-free rate of 8%, an appropriate time horizon of five years, and a variance for each firm of 10%, apply the OPM to calculate the value of equity of the two firms before the merger. Under the further assumption that the correlation between the percentage returns on firms A and B is zero, calculate the value of equity and the value of debt of the merged firm, using the OPM.
a) How does the new market value of equity and debt of the merged firm compare with the sum of the values of equity and debt of the constituent firms that combined in the merger?
b) How much additional debt would the merged firm have to issue to restore equity holders to their original position?