Problem:
The Chocolate Ice Cream Co. and the Vanilla Ice Cream Co. have agreed to merge and form the Fudge Swirl Consolidated. Both companies are exactly alike except that they are located in different towns. The end-of-period value of each firm is determined by the weather, as shown below. There will be no synergy to the merger.
State Probability Value
Rainy .1 $100,000
Warm .4 $200,000
Hot .5 $400,000
The weather conditions in each town are independent of those in the other. Furthermore, each company has an outstanding debt claim of $200,000. Assume that no premiums are paid in the merger.
What are the possibile values of the combined company?
What are the possible values of end of period debt values and stock values after the merger?
Show that the bondholders are better off and the stockholders are worse off in the combined firm than they would have been if the firms had remained separate?