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12-1
Chapter 12
Answers to Review Problems
Finance For Executives – 4th Edition
1. Valuation issues.
a.
When the yield on government securities rises, equity investors require a higher return to hold
shares. This reduces share prices and decreases (not increases) price-earnings ratios.
b.
c.
In a leveraged buyout, debt financing provides more than valuable tax savings. It is also a device
to monitor management (more debt means more pressure on management to generate cash to
2. Some issues in mergers and acquisitions.
a.
It can create value through synergistic revenue enhancement (post-merger revenues exceeding the
sum of the revenues of the pre-merged firms).
b.
12-2
c.
Growth in earnings per share does not necessarily create value. Value will be created only if the
merger has a positive net present value.
d.
3. Leveraged buyout.
Value creation
• Lower taxes from additional annual depreciation expenses resulting from the revaluation of
Value destruction
• Higher cost of equity capital
• Increased probability of not being able to service debt
3. Mergers and price-to-earnings ratios.
a.
The maximum price that Maltonese should pay for the acquisition of Targeton is $60 million.
This is the value of Targeton standing alone—$45 million (1.5 million shares at $30 each)—plus
b.
The following table shows how the P/E ratio of the merged firm can be estimated.
Maltonese Inc.
Targeton Corp.
1. Share price
$60
$30
2. Number of shares outstanding
5 million
1.5 million
12-3
Merged firm
7. Earnings after tax (from line 5)
$30 million + $7.5 million = $37.5 million
8. Market value of equity (from line 3 + gains from
merger)
$300 million + $45 million + $15 million =
$360 million
4. Mergers and price-to-earnings ratios.
a.
The following table shows how the earnings per share, price-to earnings ratio, and share price of
the merged firms can be calculated.
Mergecandor Corp.
Tenderon Inc.
1. Share price
$30
$15
2. Number of shares outstanding
2 million
1 million
Merged firm
7. Earnings after tax (from line 5)
$8 million + $3 million = $11 million
8. Market value of equity (from
$60 million + $15 million = $75 million
Note that since the merger does not create any wealth gain, the net present value of the
transaction is zero. Further, since the exchange ratio is exactly equal to the ratio of the two
companies’ share price, there must not be any wealth transfer between the shareholders of
Mergecandor and those of Tenderon. This is confirmed by the calculated share price of the
12-4
b.
If the P/E ratio of Mergecandor stays at 7.5 after the merger, we have the following:
Merged firm
13. P/E ratio
7.5
14. Market value of equity (line 13 line 7)
$82.5 million
15. Share price (line 14/line 9)
$33
5. Net present value of an acquisition.
a.
The amount of wealth created by the merger is the present value of the $1,000,000 savings on the
administrative costs of the two firms. This is the present value of a constant cash flow of
b.
If Motoran acquires Tortoran, it will get two things. First, the value of Tortoran standing alone
($20 million) plus $8 million of value created by the merger, for a total of $28 million. If the $25
6. Discounted cash flow valuation.
The minimum price that David Murlow should ask for his firm is the present value of the cash
flows expected from the assets of the firm standing alone. The value of the firm is the sum of the
12-5
CFA = EBIT(1 – Tc) + Depreciation expenses – WCR – Net capital expenditures
Using a spreadsheet similar to Exhibit 12.6 we can estimate the equity value of Murlow Company
as follows:
A B C D E F
1$ millions
2
3Current Year 1 Year 2 Year 3 Year 4
4
5 Sales growth rate 6.00% 6.00% 6.00% 4.00%
6 Operating margin as percent of sales 20.00% 20.00% 20.00% 20.00%
7 WCR in percent of sales 18.0% 18.00% 18.00% 18.00% 18.00%
18
19 Beginning Year 1
20
21 WACC 10.00%
22 DCF value of assets $1,030
23 less book value of debt $0
24 equals DCF value of equity $1,030
25
36
END-OF-YEAR FORECAST
12-6
7. Discounted cash-flow valuation.
a.
Apply the following three-step method:
Step 1:
CFAPortal = EBIT(1 – Tax rate) – WCR
Step 2:
Estimate LMC’s weighted average cost of capital (WACC).
1. Cost of equity according to the capital asset pricing model = 5% + 1.05 × 5% = 10.25%
Step 3:
Using a spreadsheet similar to Exhibit 12.6 estimate the DCF value of Portal’s equity from the
forecasting assumptions:
12-7
A
B
C
D
E
F
G
1
$ millions
END-OF-YEAR FORECAST
2
3
Current
Year 1
Year 2
Year 3
Year 4
Year 5
4
5
Sales growth rate
5.00%
5.00%
5.00%
5.00%
3.00%
13
14
equals cash flow from assets
$68.9
$77.3
$86.3
$96.1
$107.8
15
16
Residual value end-of-year 4
$2,741.8
17
18
19
Beginning Year 1
20
21
WACC
6.93%
22
DCF value of assets
$2,373
23
less book value of debt
$500
24
equals DCF value of equity
$1,873
25
Rows 5 to 7, and 23, plus cell B8are data.
b.
To estimate the changes in equity value resulting from the suggested performance improvements,
simply modify the relevant data in the spreadsheet used in part a. To find the estimated amount of
value created, simply deduct $1,873 million, the DCF value of Portal’s equity without
12-8
improvements, that is its value “as is.”
Action
Expected Cash Flows from
Assets
($ millions)
New DCF
Value
Value Created
None
$68.9; $77.3; $86.3; $96.1
2,741.81
$1,873 million
–
Faster growth
$68.5: $77.3; $86.8;$97.2;
$3,193.71
$2,220 million
$347 million
Higher operating margin
$73.6; $82.2; $91.5;$101.6
$ 2,000 million
$127 million
9. Alternatives to cash acquisition.
a.
From equation 12.3, where the constant growth rate g is set equal to zero, the discounted cash
flow (DCF) value of the $800,000 indefinitely annual increase to Osiris’ cash flow from assets is:
million10$
08.
000,800$
capitalofCost
increaseflowcashannualExpected
DCF Osiristo ===
b.
After the acquisition, the market value of Osiris would be:
Osiris’ valuepost acquisition = Osiris’ valuestanding alone + Value of the acquisitionto Osiris
million.
c.
Under the exchange of shares alternative, the NPV of the acquisition would be the value of the
acquisition minus its cost or $17.5 million ($40 million less $22.5 million). Under the cash
alternative, it would be $20 million ($40 million less $20 million).
10. Cash or Stock offer?
a.
Mirandel’s share price, PMirandel, is the present value of an annuity equal to the dividend expected
for next year growing at a constant rate, g (5 percent), forever. Equation 12.1 and the appendix to
the chapter show that we can write:
The following table shows how we can calculate Mirandel’s cost of capital using this equation:
1. Current dividend (per share)
$1.50
2. Expected dividend growth rate, g
5%
3. Dividend next year [line 1 (1 + line 2)]
$1.575
b.
If Mirandel acquires Tarantel, the dividend would grow by 8 percent instead of 5 percent.
Applying the price formula from above, we get:
c.
If Mirandel offers $50 in cash for each outstanding share of Tarantel, it will acquire Tarantel for
$25 million ($50 .5 million shares). The net present value of the acquisition would be $1.12
million ($26.12 million – $25 million). If it offers 756,000 of its shares in exchange of the
Whether Mirandel should make a cash or a stock exchange offer depends upon the following
considerations:
1. If Mirandel’s management believes that Mirandel’s shares are currently overvalued, the
stock exchange offer makes more sense than a cash offer.
2. If cash is offered to Tarantel’s shareholders, they would receive a fixed price. If the
merger is very successful, they would not benefit from the additional wealth created by
