Bootstrap (earnings) effect

Bootstrap effect
The short-run increase in earnings per share which occurs in a share for share exchange when a company trading on a higher price to earnings ratio acquires a company trading on a lower price to earnings ratio.

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Financial and Market Data for Acquirer and Target

Financial/Price Data		Acquirer	Target
Sales		$400 million	$105 million
Net income		$80 million	$22 million
Cash flow		$140 million	$42 million
Book value		$320 million	$72 million
Number of common shares outstanding		50 million	20 million
Current market price of common stock		$30.50	$20.00
Recent market price range		$34-26	$22-18

(Question)
If Acquirer issues common stock at the current market price and uses the proceeds to acquire Target's outstanding common stock, the bootstrap earnings effect on post merger earnings would most likely occur if Target's acquisition price:
A. is $20 or lower.
B. is $20 or higher.
C. is $20 or lower and Acquirer's post merger P/E remains at the current level.

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Answer: C

The bootstrap effect only occur when

• Acquirer's P/E ratio is higher than Target's and
• Acquirer's P/E post merger does not decline.

Financial and Market Data for Acquirer and Target

Financial/Price Data		Acquirer	Target
P/E		$30.50/(80/50) = 19.06	$20.00/(22/20) =18.18

Therefore, the combined earnings per share after the merger would be higher if Acquirer issued stock at the current price and bought Target at current market price ($20) or less per share.