Finance Chapter 12 Valuation Issues When The Yield Government Securities

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.

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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

5. Earnings after tax (line 3/line 4)

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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

4. P/E ratio

5. Earnings after tax (line 3/line 4)

6. Earnings per share (line 5/line 2)

Merged firm

7. Earnings after tax (from line 5)

$8 million + $3 million = $11 million

9. Number of shares outstanding

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%

13

14 equals cash flow from assets $58.2 $61.7 $65.4 $70.0

15

16 Terminal valuevalue of assets end-of-year 3 $1,167

17

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

26 Rows 5 to 7, 21 and 23, plus cell B8 are data.

28 The formula in cell C9 is: =C6*C8. Then copy formula in cell C9 to cells D9, E9, and F9.

29 The formula in cell C10 is: =C9*(1-.4). Then copy formula in cell C10 to cells D10, E10, and F10.

30 The formula in cell B11 is: =B7*B8. Then copy formula in cell B11 to cells C11, D11, E11, and F11.

31

32 The formula in cell C14 is: =C10+C12. Then copy formula in cell C14 to cells D14, E14, and F14.

33 The formula in cell E16 is: =F14/(B21-F5).

34 The formula in cell B22 is: =NPV(B21,C14:E14)+E16/(1+B21)^3.

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%

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

26

27

28

29

The formula in cell C10 is: =C9*(1-.4). Then copy cell C10 to cells D10, E10, F10, and G10.

30

31

32

33

34

35

The formula in cell B24 is: =B22-B23.

36

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

6

sales

16.00%

17.00%

18.00%

20.00%

7

WCR in percent of sales

18.0%

18.00%

8

Sales

9

EBIT

10

EBIT× (1 – Tax rate of 40%)

11

WCR at year-end

12

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 ===

Lower cost of capital

$68.9; $77.3; $86.3;

$2,074 million

$201 million

Combined actions

$89.1; $83.2; $93.1; $103.7

$2,680 million

$807 million

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

4. Earnings after tax

$2 million

5. Number of shares outstanding

2 million

6. Earnings per share (line 4/line 5)

7. P/E ratio

20

8. PMirandel (line 7  line 6)

$20

9. Cost of capital [(line 3/line 8) + line 2]

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