Answered: Estimates of Hill's Hardware Data for…

FINANCIAL ACCOUNTING

10th Edition

ISBN:9781259964947

Author:Libby

Publisher:Libby

Chapter1: Financial Statements And Business Decisions

Section: Chapter Questions

Problem 1Q

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MERGER ANALY SIS Smitty’s Home Repair Company, a regional hardware chain that specializes in doit-
yourself materials and equipment rentals, is cash rich because of several consecutive good years. One of
the alternative uses for the excess funds is an acquisition. Linda Wade, Smitty’s treasurer and your boss,
has been asked to place a value on a potential target, Hill’s Hardware, a small chain that operates in an
adjacent state, and she has enlisted your help.
Table IC 21.1 indicates Wade’s estimates of Hill’s earnings potential if it comes under Smitty’s management
(in millions of dollars). The interest expense listed here includes the interest (1) on Hill’s existing
debt, (2) on new debt that Smitty’s would issue to help finance the acquisition, and (3) on new debt
expected to be issued over time to help finance expansion within the new “H division,” the code name
given to the target firm. The retentions represent earnings that will be reinvested within the H division to
help finance its growth.
Hill’s Hardware currently uses 40% debt financing, and it pays federal-plus-state taxes at a 30%
rate. Security analysts estimate Hill’s beta to be 1.2. If the acquisition were to take place, Smitty’s would
increase Hill’s debt ratio to 50%, which would increase Hill’s beta to 1.3. Further, because Smitty’s is
highly profitable, taxes on the consolidated firm would be 40%. Wade realizes that Hill’s Hardware also
generates depreciation cash flows, but she believes that these funds would have to be reinvested within
the division to replace worn-out equipment.
Wade estimates the risk-free rate to be 9% and the market risk premium to be 4%. She also estimates
that cash flows after 2021 will grow at a constant rate of 6%. Smitty’s management is new to the merger
game, so Wade has been asked to answer some basic questions about mergers as well as to perform the
merger analysis. To structure the task, Wade has developed the following questions, which you must
answer and then defend to Smitty’s board.
a. Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax
considerations, (2) risk reduction, (3) control, (4) purchase of assets at below-replacement cost, and
(5) synergy. In general, which of the reasons are economically justifiable? Which are not? Which fit
the situation at hand? Explain.
b. Briefly describe the differences between a hostile merger and a friendly merger.
c. Use the data developed in Table IC 21.1 to construct the H division’s cash flow statements for 2018
through 2021. Why is interest expense deducted in merger cash flow statements, whereas it is not
normally deducted in a capital budgeting cash flow analysis? Why are earnings retentions deducted
in the cash flow statement?
d. Conceptually, what is the appropriate discount rate to apply to the cash flows developed in part c?
What is your actual estimate of this discount rate?
e. What is the estimated continuing value of the acquisition; that is, what is the estimated value
of the H division’s cash flows beyond 2021? What is Hill’s value to Smitty’s? Suppose another
firm were evaluating Hill’s as an acquisition candidate. Would it obtain the same value? Explain.
f. Assume that Hill’s has 10 million shares outstanding. These shares are traded relatively infrequently,
but the last trade, made several weeks ago, was at a price of $9 per share. Should Smitty’s make an
offer for Hill’s? If so, how much should it offer per share?
g. What merger-related activities are undertaken by investment bankers?

Estimates of Hill's Hardware Data for Merger Analysis
TABLE IC 21.1
2018
2019
2020
2021
Net sales
$60.0
$90.0
$1125
$127.5
Cost of goods sold (6016)
36.0
54.0
67.5
76.5
Seling/administrative expense
4.5
6.0
7.5
9.0
Interest expense
3.0
4.5
4.5
6.0
Necessary retained eamings
0.0
7.5
6.0
4.5

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