LG2 20-9 Calculation of Average Costs with Economies of Scope George’s Dry Cleaning is considering a
merger with Weezzie’s Laundry Supply Stores. George’s total operating costs of producing services
are $550,000 for sales volume (SG) of $4.5 million. Weezzie’s total operating costs of producing
services are $185,000 for a sales volume (SW) of $2 million.
a. Calculate the average cost of production for the two firms.
b. For a sales volume of $6.5 million, calculate the reduction in production costs the merged
firms need to experience such that the total average cost (ACGeorgeWeezie) for the merged firms is
Thus, the reduction in production costs needs to be ($550,000 + $185,000) – $650,000 = $85,000
LG2 20-10 Calculation of Average Costs with Economies of Scope Jenny’s Day Care is
considering a merger with Lionel’s Diaper Manufacturers. Jenny’s total operating costs of producing
services are $595,000 for sales volume (SJ) of $2.4 million. Lionel’s total operating costs of
producing services are $340,000 for a sales volume (SL) of $1,400,000.
a. Calculate the average cost of production for the two firms.
b. For a sales volume of $3.8 million, calculate the reduction in production costs the merged
firms need to experience such that the total average cost (ACJennyLionel) for the merged firms is
equal to 20 percent.
Thus, the reduction in production costs needs to be ($595,000 + $340,000) – $760,000 = $175,000
LG2 20-11 Calculation of Change in the HHI Associated with a Merger The Justice Department
has been asked to review a merger request for a market with the following four firms.
Firm Assets A $12 million B 25
million C 102 million D 3 million
a. What is the HHI for the existing market?
Firm Assets Market Share
b. If Firm A acquires Firm D, what will be the impact on the market’s level of concentration?
Firm Assets Market Share
c. If Firm C acquires Firm D, what will be the impact on the market’s level of concentration?
Firm Assets Market Share
d. What is likely to be the Justice Department’s response to the two merger applications?
The Justice Department may challenge Firm C’s application to acquire Firm D since it
LG2 20-12 Calculation of Change in the HHI Associated with a Merger The Justice Department
has been asked to review a merger request for a market with the following four firms.
Firm Assets
A $156 million
B 130 million
C 45 million
D 100 million
a. What is the HHI for the existing market?
b. If Firm B acquires Firm D, what will be the impact on the market’s level of concentration?
Firm Assets Market Share
c. If Firm C acquires Firm D, what will be the impact on the market’s level of concentration?
Firm Assets Market Share
d. What is likely to be the Justice Department’s response to the two merger applications?
The Justice Department may challenge Firm B’s application to acquire Firm D since it
LG2 20-13 Valuation of a Merger Stubborn Motors, Inc. is asking a price of $75 million to be purchased
by Rubber Tire Motor Corp. Stubborn Motors currently has total cash flows of $2 million that are
expected to grow indefinitely by one percent annually. Managers estimate that because of synergies
the merged firm’s cash flows will increase by $4 million the first year after the merger and these cash
flows will grow by an additional 4 percent in years 2 through 4 following the merger. After the first
four years, these incremental cash flows will grow at a rate of 1 percent annually. The WACC for the
merged firms is 10 percent. Calculate the NPV of the merger. Should Rubber Tire Motor Corporation
agree to acquire Stubborn Motors for the asking price of $75 million?
The incremental cash flows for the first four years after the merger are:
Year after merger 1 2 3 4
NPV = $70.33m – $75m = -$4.67m
This merger would not be beneficial for the stockholders of the bidder firm. Their wealth would
decrease by $4.67 million as a result of the merger.
LG2 20-14 Valuation of a Merger You own stock in Make-UP-Artists, Inc. which has just made a bid of
$30 million to purchase MHM Corporation. MHM Corp. currently has total cash flows of $2.5
million that are expected to grow indefinitely by 2 percent annually. Managers estimate that because
of synergies the merged firm’s cash flows will increase by $500,000 in the first year after the merger
and these cash flows will grow by an additional 4 percent in years 2 through 5 following the merger.
After the first five years, these incremental cash flows will grow at a rate of 2 percent annually. The
merged firms are expected to have a beta = 1.2, the risk-free rate is 4.5 percent, and the market risk
premium is currently 5.5 percent. Calculate the NPV of the merger. Will you vote in favor of the
merger?
The incremental cash flows for the first four years after the merger are:
Year after merger 1 2 3 4 5
Cash flow from $2.5m(1.02) $2.5m(1.02)2 $2.5m(1.02)3 $2.5m(1.02)4 $2.5m(1.02)5
This merger would be beneficial for the stockholders of the bidder firm. The value of the firm
LG4 20-15 Calculating Creditor and Stockholder Payoffs in a Chapter 7 Bankruptcy: You own
$25,000 in subordinated debt of Local Crossings, Inc. which declared bankruptcy on May 15,
2015 through a Chapter 7 filing. Local Crossings’ balance sheet at the time of the bankruptcy
filing is listed as follows.
Local Crossings, Inc.
Balance Sheet as of May 15, 2015
(in millions of dollars)
Assets Liabilities and Equity
Current assets: Current liabilities:
Cash and marketable Accrued wages (10,500 employees) $ 20
securities $ 406 Unpaid employee benefits 15
Accounts receivable 978 Unsecured customer deposits 50
Inventory 1,038 Accrued taxes 375
Total $2,422 Accounts payable 841
Notes payable to banks 1,518
Fixed assets: Total $2,819
equipment $7,253 Long-term debt:
Less: Depreciation 1,050 First mortgage $1,200
Net plant and Subordinate debentures 2,018
equipment $6,203 Total $3,218
Stockholders’ equity:
Preferred stock (100 million shares) $ 100
Common stock and
paid-in surplus 1,500
(200 million shares)
Retained earnings 988
Total $2,588
Total assets $8,625 Total liabilities and equity $8,625
Proceeds from liquidation of assets: $4,850m
Administrative expenses associated with the bankruptcy proceedings 15m
Taxes due to federal, state, and other governmental agencies 375m
Funds available for secured creditors: $4,365m
First mortgage 1,200m
Funds available for unsecured creditors: $3,165m
Accounts payable $ 841m $608.13m $608.13m 72.31%
Notes payable to banks 1,518m 1,097.66m 1,518.00mb 100.00
Subordinate debentures 2,018m 1,459.21m 1,038.87m b 51.48
Total $4,377m $3,165.00m $3,165.00m
a $3,165 million is available to pay $4,377 million in unsecured creditors. Thus, the pro rata
to them.
LG4 20-16 Calculating Creditor and Stockholder Payoffs in a Chapter 7 Bankruptcy:
WorldGone, Inc. declared bankruptcy on September 25, 2015 through a Chapter 7 filing.
WorldGone’s balance sheet at the time of the bankruptcy filing is listed as follows.
WorldGone, Inc.
securities $ 263 Unpaid employee benefits 15
Accounts receivable 1,428 Unsecured customer deposits 69
Inventory 2,100 Accrued taxes 252
Total $3,791 Accounts payable 711
Notes payable to banks 1,975
equipment $6,504 Total $3,446
Stockholders’ equity:
Preferred stock (100 million shares) $ 100
Common stock and
paid-in surplus 2,500
The accrued wages were earned within the last 90 days prior to filing for bankruptcy. The unpaid
among the WorldGone’s creditors and stockholders.
The distribution of the $5,985 million of funds is as follows:
Proceeds from liquidation of assets: $5,985m
Administrative expenses associated with the bankruptcy proceedings 25m
Taxes due to federal, state, and other governmental agencies 252m
Funds available for secured creditors: $5,596m
First mortgage 1,232m
Funds available for unsecured creditors: $4,364m
Accounts payable $ 711m $633.22m $633.220m 89.06%
Notes payable to banks 1,975m 1,758.96m 1,975.00mb 100.00
Subordinate debentures 2,214m 1,971.82m 1,755.78m b 79.30
Total $4,900m $4,364.00m $4,364.00m
a $4,364 million is available to pay $4,900 million in unsecured creditors. Thus, the pro rata
to them.
LG5 20-17 Calculation of Altman’s Z-Score: Use the following financial statements for Lake of
Egypt Marina to calculate and interpret the Altman’s Z-score for this firm as of 2015.
Lake of Egypt Marina, Inc.
Balance Sheet as of December 31, 2015 and 2014
(in millions of dollars)
Assets 2015 2014 Liabilities and Equity 2015 2014
Current assets: Current liabilities :
Cash and marketable Accrued wages and
securities $ 75 $ 65 taxes $ 40 $ 43
Accounts receivable 115 110 Accounts payable 90 80
Inventory 200 190 Notes payable 80 70
Total $ 390 $ 365 Total $ 210 $ 193
Fixed assets: Long-term debt: $ 300 $ 280
Gross plant and
equipment $ 580 $ 471 Stockholders’ equity:
Less: Depreciation 110 100 Preferred stock (5 million shares) $ 5 $ 5
Net plant and Common stock and
equipment $ 470 $ 371 paid-in surplus 65 65
Other long-term assets 50 49 (65 million shares)
Total $ 520 $ 420 Retained earnings 330 242
Total $ 400 $ 312
Total assets $ 910 $ 785 Total liabilities and equity $ 910 $ 785
2015 2014
Net sales (all credit) $ 515 $ 432
Less: Cost of goods sold 260 200
Gross profits $ 255 $ 232
X1 = Net working capital/Total assets = ($390m – $210m) / $910m = 0.1978
