Charlie Corporation is analyzing the possible acquisition of Delta Inc. Neither firm has debt. The forecasts of Charlie show that the purchase would increase its annual after-tax cash flow by $425,000 indefinitely. The current market value of Delta is $8.8 million. The current market value of Charlie is $22 million. The appropriate discount rate for the incremental cash flows is 8%. Charlie is trying to decide whether it should offer 35% of its stock or $12 million in cash to Delta. Required What is the synergy from the merger? What is the value of Delta to Charlie? What is the cost to Charlie of each alternative? What is the NPV of Charlie of each alternative?

Charlie Corporation is analyzing the possible acquisition of Delta Inc. Neither firm has debt. The forecasts of Charlie show that the purchase would increase its annual after-tax cash flow by $425,000 indefinitely. The current market value of Delta is $8.8 million. The current market value of Charlie is $22 million. The appropriate discount rate for the incremental cash flows is 8%. Charlie is trying to decide whether it should offer 35% of its stock or $12 million in cash to Delta. Required What is the synergy from the merger? What is the value of Delta to Charlie? What is the cost to Charlie of each alternative? What is the NPV of Charlie of each alternative?

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter14: Capital Structure Management In Practice

Section: Chapter Questions

Problem 34P

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Hager’s Home Repair Company, a regional hardware chain, which specializes in “do-it-yourself” materials and equipment rentals, is considering an acquisition of Lyon Lighting (LL). Doug Zona, Hager’s treasurer and your boss, has been asked to place a value on the target and he has enlisted your help. LL has 20 million shares of stock trading at $12 per share. Security analysts estimate LL’s beta to be 1.25. The risk-free rate is 5.5% and the market risk premium is 4%. LL’s capital structure is 20% financed with debt at an 8% interest rate; any additional debt due to the acquisition also will have an 8% rate. LL has a 25% federal-plus-state tax rate, which will not change due to the acquisition. The following data incorporate expected synergies and required levels of total net operating capital for LL should Hager’s complete the acquisition. The forecasted interest expense includes the combined interest on LL’s existing debt and on new debt. After 2024, all items are expected to grow at a constant 6% rate. Note: aDebt is added on the first day of the year, so the 2019 debt is LL’s debt prior to the acquisition. Hager’s management is new to the merger game, so Zona has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Zona has developed the following questions, which you must answer and then defend to Hager’s board: Briefly describe the differences between a hostile merger and a friendly merger.
Hager’s Home Repair Company, a regional hardware chain, which specializes in “do-it-yourself” materials and equipment rentals, is considering an acquisition of Lyon Lighting (LL). Doug Zona, Hager’s treasurer and your boss, has been asked to place a value on the target and he has enlisted your help. LL has 20 million shares of stock trading at $12 per share. Security analysts estimate LL’s beta to be 1.25. The risk-free rate is 5.5% and the market risk premium is 4%. LL’s capital structure is 20% financed with debt at an 8% interest rate; any additional debt due to the acquisition also will have an 8% rate. LL has a 25% federal-plus-state tax rate, which will not change due to the acquisition. The following data incorporate expected synergies and required levels of total net operating capital for LL should Hager’s complete the acquisition. The forecasted interest expense includes the combined interest on LL’s existing debt and on new debt. After 2024, all items are expected to grow at a constant 6% rate. Note: aDebt is added on the first day of the year, so the 2019 debt is LL’s debt prior to the acquisition. Hager’s management is new to the merger game, so Zona has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Zona has developed the following questions, which you must answer and then defend to Hager’s board: What are the steps in valuing a merger using the compressed APV approach?
Hager’s Home Repair Company, a regional hardware chain, which specializes in “do-it-yourself” materials and equipment rentals, is considering an acquisition of Lyon Lighting (LL). Doug Zona, Hager’s treasurer and your boss, has been asked to place a value on the target and he has enlisted your help. LL has 20 million shares of stock trading at $12 per share. Security analysts estimate LL’s beta to be 1.25. The risk-free rate is 5.5% and the market risk premium is 4%. LL’s capital structure is 20% financed with debt at an 8% interest rate; any additional debt due to the acquisition also will have an 8% rate. LL has a 25% federal-plus-state tax rate, which will not change due to the acquisition. The following data incorporate expected synergies and required levels of total net operating capital for LL should Hager’s complete the acquisition. The forecasted interest expense includes the combined interest on LL’s existing debt and on new debt. After 2024, all items are expected to grow at a constant 6% rate. Note: aDebt is added on the first day of the year, so the 2019 debt is LL’s debt prior to the acquisition. Hager’s management is new to the merger game, so Zona has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Zona has developed the following questions, which you must answer and then defend to Hager’s board: Why can’t we estimate LL’s value to Hager’s by discounting the FCFs at the WACC? What method is appropriate? Use the projections and other data to determine the LL division’s free cash flows and interest tax savings for 2020 through 2024. Notice that the LL division’s sales are expected to grow rapidly during the first years before leveling off at a sustainable long-term growth rate.
The Rivoli Company has no debt outstanding, and its financial position is given by the following data: What is Rivoli’s intrinsic value of operations (i.e., its unlevered value)? What is its intrinsic stock price? Its earnings per share? Rivoli is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to a capital structure with 30% debt based on market values, its cost of equity, rs, will increase to 12% to reflect the increased risk. Bonds can be sold at a cost, rd, of 7%. Based on the new capital structure, what is the new weighted average cost of capital? What is the levered value of the firm? What is the amount of debt? Based on the new capital structure, what is the new stock price? What is the remaining number of shares? What is the new earnings per share?
Wansley Lumber is considering the purchase of a paper company, which would require an initial investment of $300 million. Wansley estimates that the paper company would provide net cash flows of $40 million at the end of each of the next 20 years. The cost of capital for the paper company is 13%. Should Wansley purchase the paper company? Wansley realizes that the cash flows in Years 1 to 20 might be $30 million per year or $50 million per year, with a 50% probability of each outcome. Because of the nature of the purchase contract, Wansley can sell the company 2 years after purchase (at Year 2 in this case) for $280 million if it no longer wants to own it. Given this additional information, does decision-tree analysis indicate that it makes sense to purchase the paper company? Again, assume that all cash flows are discounted at 13%. Wansley can wait for 1 year and find out whether the cash flows will be $30 million per year or $50 million per year before deciding to purchase the company. Because of the nature of the purchase contract, if it waits to purchase, Wansley can no longer sell the company 2 years after purchase. Given this additional information, does decision-tree analysis indicate that it makes sense to purchase the paper company? If so, when? Again, assume that all cash flows are discounted at 13%.
David Lyons, CEO of Lyons Solar Technologies, is concerned about his firms level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant: e. Suppose the expected free cash flow for Year 1 is 250,000 but it is expected to grow faster than 7% during the next 3 years: FCF2 = 290,000 and FCF3 = 320,000, after which it will grow at a constant rate of 7%. The expected interest expense at Year 1 is 128,000, but it is expected to grow over the next couple of years before the capital structure becomes constant: Interest expense at Year 2 will be 152,000, at Year 3 it will be 192,000 and it will grow at 7% thereafter. What is the estimated horizon unlevered value of operations (i.e., the value at Year 3 immediately after the FCF at Year 3)? What is the current unlevered value of operations? What is the horizon value of the tax shield at Year 3? What is the current value of the tax shield? What is the current total value? The tax rate and unlevered cost of equity remain at 25% and 14%, respectively.
Hasting Corporation is interested in acquiring Vandell Corporation. Vandell has 1.5 million shares outstanding and a target capital structure consisting of 30% debt; its beta is 1.4 (given its target capital structure). Vandell has $10.19 million in debt that trades at par and pays an 8% interest rate. Vandell’s current free cash flow (FCF0) is $2 million per year and is expected to grow at a constant rate of 5% a year. Vandell pays a 25% combined federal-plus-state tax rate, the same rate paid by Hastings. The risk-free rate of interest is 5%, and the market risk premium is 6%. Hasting’s first step is to estimate the current intrinsic value of Vandell. What is Vandell’s cost of equity? What is its weighted average cost of capital? What is Vandell’s intrinsic value of operations? (Hint: Use the free cash flow corporate valuation model from Chapter 7.) Based on this analysis, what is the minimum stock price that Vandell’s shareholders should accept?
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