Ge Proposed Acquisition of Honeywell

1. Gallinelli (G) is a risk arbitrageur. The stock of the target is bought after a merger announcement and held until the deal is officially consummated. A risk arbitrageur purchases the stock at a discount relative to its eventual value at the close of the merger. In a stock merger, rather than holding stock until consummation the arbitrageur is betting that the deal will go through by short selling the acquirer stock for each target share purchased according to the given exchange ratio to hedge out market risk. By holding the short position the arbitrageur is protected against the risk that the price of the acquirer’s stock drops. The remaining risk is deal risk (likelihood of whether the deal is completed or not). Merger arbitrage trades have the goal of locking in a spread – thus they are unaffected by broad stock market fluctuations if the market is relatively stable. G holds 10m shares in H (target) and a short position of 10m shares in GE. She constructed her portfolio according to the exchange ratio on 20.10.2000. If the deal is successful the H shares will be converted into GE shares according to the exchange ratio. Based on the exchange ratio (exhibit 1) and stock prices (exhibit 2) from 20.10.2000 this yields a gross spread of $5.62 per share (spread of 13.56% relative to H share price) (app. 1). Prices from 20.10.2000 were used because G entered her positions on that date. If G only purchased H shares there is a risk that the GE share price drops and thus the spread would be eliminated since the exchange would be worse. By going short on GE shares simultaneously she is protected against such risk and the spread is locked in (app. 2: example calculation if GE price drops/rises, net profit/loss remains constant).

2. First a sensitivity analysis of the discounted cash flow analysis (DCF) was done. Since only data used by analysts and case writer is available, the FCF forecast is considered reasonable. However, the result depends heavily on assumptions –...