Home Repair Company, a regional hardware chain that specializes in “do-it-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. Doug Zona, Hager’s treasurer and your boss, has been asked to place a value on a potential target, Lyons Lighting (LL), a chain that operates in several adjacent states, and he has enlisted your help. The table below indicates Zona’s estimates of LL’s earnings potential if it came under Hager’s management (in millions of dollars). The interest expense listed here includes the interest (1) on LL’s existing debt, which is $55 million at a rate of 9%, and (2) on new debt expected to be issued over time to help finance expansion within the new “L division,” the code name given to the target firm. If acquired, LL will face a 40% tax rate. Security analysts estimate LL’s beta to be 1.3. The acquisition would not change Lyons’s capital structure, which is 20% debt. Zona realizes that Lyons Lighting’s business plan also requires certain levels of operating capital and that the annual investment could be significant. The required levels of total net operating capital are listed below. Zona estimates the risk-free rate to be 7% and the market risk premium to be 4%. He also estimates that free cash flows after 2012 will grow at a constant rate of 6%. Following are projections for sales and other items. 2007 2008 2009 2010 2011 2012 Net sales $ 60.00 $ 90.00 $112.50 $127.50 $139.70 CGs (60%) 36.00 54.00 67.50 76.50 83.80 Selling/administrative expense 4.50 6.00 7.50 9.00 11.00 Interest expense 5.00 6.50 6.50 7.00 8.16 Total net operating capital $150.00 150.00 157.50 163.50 168.00 173.00 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. Use the data developed in the table to construct the L division’s free cash flows for 2008 through 2012. Why are we identifying interest expense separately since it is not normally included in calculating free cash flows or in a capital budgeting cash flow analysis? Why is investment in net operating capital included when calculating the free cash flow?
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Home Repair Company, a regional hardware chain that specializes in “do-it-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. Doug Zona, Hager’s treasurer and your boss, has been asked to place a value on a potential target, Lyons Lighting (LL), a chain that operates in several adjacent states, and he has enlisted your help.
The table below indicates Zona’s estimates of LL’s earnings potential if it came under Hager’s management (in millions of dollars). The interest expense listed here includes the interest (1) on LL’s existing debt, which is $55 million at a rate of 9%, and (2) on new debt expected to be issued over time to help finance expansion within the new “L division,” the code name given to the target firm. If acquired,
LL will face a 40% tax rate. Security analysts estimate LL’s beta to be 1.3. The acquisition would not change Lyons’s capital structure, which is 20% debt. Zona realizes that Lyons Lighting’s business plan also requires certain levels of operating capital and that the annual investment could be significant. The required levels of total net operating capital are listed below.
Zona estimates the risk-free rate to be 7% and the market risk premium to be 4%. He also estimates that free
2007 2008 2009 2010 2011 2012
Net sales $ 60.00 $ 90.00 $112.50 $127.50 $139.70
CGs (60%) 36.00 54.00 67.50 76.50 83.80
Selling/administrative expense 4.50 6.00 7.50 9.00 11.00
Interest expense 5.00 6.50 6.50 7.00 8.16
Total net operating capital $150.00 150.00 157.50 163.50 168.00 173.00
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.
- Use the data developed in the table to construct the L division’s free cash flows for 2008 through 2012. Why are we identifying interest expense separately since it is not normally included in calculating free cash flows or in a capital budgeting cash flow analysis? Why is investment in net operating capital included when calculating the
free cash flow ?
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