LG5 20-18 Calculation of Altman’s Z-Score: Use the following financial statements for
Garners’ Platoon Mental Health Care, Inc., to calculate and interpret the Altman’s Z-score for this
firm.
Garners’ Platoon Mental Health Care, Inc.
Balance Sheet as of December 31, 2015
(in millions of dollars)
Assets Liabilities and Equity
Current assets: Current liabilities :
Cash and marketable Accrued wages and
securities $ 247 taxes $ 186
Accounts receivable 652 Accounts payable 510
Inventory 1,035 Notes payable 513
Total $1,934 Total $1,209
Fixed assets: Long-term debt: $1,818
Gross plant and
equipment $3,419 Stockholders’ equity:
Less: Depreciation 494 Preferred stock (35 million shares) $ 35
Net plant and Common stock and
equipment $2,925 paid-in surplus 375
Other long-term assets 525 (375 million shares)
Total $3,450 Retained earnings 1,947
Total $2,357
Total assets $5,384
Total liabilities and equity $5,384
Net sales (all credit) $2,964
Less: Cost of goods sold 1,420
Gross profits $1,544
Less: Depreciation and other operating expenses 120
Earnings before interest and taxes (EBIT) $1,424
Net income available to common stockholders $ 746
Less: Common stock dividends $ 375
Addition to retained earnings $ 371
Per (common) share data:
Earnings per share (EPS) $1.989
X1 = Net working capital/Total assets = ($1,934m – $1,209m) / $5,384m = 0.1347
LG5 20-19 Calculation of Bankruptcy Probability Suppose a linear probability model you have
developed finds there are two factors influencing the past bankruptcy behavior of firms: the debt
ratio and the profit margin. Based on past bankruptcy experience, the linear probability model is
estimated as:
LG5 20-20 Calculation of Bankruptcy Probability A linear probability model you have developed
finds there are two factors influencing the past bankruptcy behavior of firms: the equity
multiplier and the total asset turnover ratio. Based on past bankruptcy experience, the linear
probability model is estimated as:
advanced
problems
LG1 20-21 Economies of Scope A survey of a local market has provided the following average cost data:
Johnson Construction Corp. (JCC) has assets of $3 million and an average cost of 20 percent.
Anderson Architects (AA) has assets of $4 million and an average cost of 30 percent. Cole Home
Builders (CHB) has assets of $4 million and an average cost of 25 percent. For each firm, average
costs are measured as a proportion of assets. JCC is planning to acquire AA and CHB with the
expectation of reducing overall average costs by eliminating the duplication of services.
a. What should the average cost after the acquisition be for JCC to justify this merger?
b. If JCC plans to reduce operating costs by $500,000 after the merger, what will the average cost be
for the new firm?
LG1 20-22 Economies of Scope A survey of a national market has provided the following average cost
data: Jackson County Construction (JCC) has assets of $2.55 million and an average cost of 30
percent. Arkansas Architects (AA) has assets of $1.7 million and an average cost of 25 percent.
Colorado Home Builders (CHB) has assets of $1 million and an average cost of 15 percent. For each
firm, average costs are measured as a proportion of assets. JCC is planning to acquire AA and CHB
with the expectation of reducing overall average costs by eliminating the duplication of services.
a. What should the average cost after the acquisition be for JCC to justify this merger?
b. If JCC plans to reduce operating costs by $425,000 after the merger, what will the average cost be
for the new firm?
Average cost:
The average cost after merger = $0.915m / $5.250m = 17.43 percent
LG2 20-23 Calculation of Change in the HHI Associated with a Merger Cakes, Corp. currently
has a 60 percent market share in banking services, followed by Cookies, Inc., with 20 percent
and Dippen Dough with 20 percent.
a. What is the concentration ratio as measured by the Herfindahl-Hirschman Index (HHI)?
b. If Cakes, Corp. acquires Cookies, Inc., what will be the new HHI?
c. Assume the Justice department will allow mergers as long as the changes in HHI do not
exceed 1,400. What is the minimum amount of assets that Cakes, Corp will have to divest after it
merges with Cookies, Inc.?
If the merger stands with no adjustment, then X = 80 and Y = 0. But some portion of X must be
Using the formula: Q =
2a
4ac) –
b
( b–
2/1
2
, we get Q = 73.1662 percent, which means Cakes,
LG2 20-24 Calculation of Change in the HHI Associated with a Merger Tractor Supply, Corp.
currently has a 50 percent market share in banking services, followed by Farm Equipment, Inc.,
with 30 percent and Plow Mart with 20 percent.
a. What is the concentration ratio as measured by the Herfindahl-Hirschman Index (HHI)?
b. If Tractor Supply, Corp. acquires Plow Mart, Inc., what will be the new HHI?
c. Assume the Justice department will allow mergers as long as the changes in HHI do not
exceed 1,500. What is the minimum amount of assets that Tractor, Corp will have to divest after
it merges with Plow Mart, Inc.?
If the merger stands with no adjustment, then X = 70 and Z = 0. But some portion of X must be
LG3 20-25 Valuation of a Merger The managers of BSW, Inc. have approached KCMP Corp. about a
possible merger. KCMP Corp. is asking a price of $72 million to be purchased by BSW, Inc. KCMP
Corp. currently has total cash flows of $6 million that are expected to grow at two percent annually
$7.12m $7.27m ?
Present value of cash flows = ———- + ———— + ————- + $54.09m = $72m
from the merger (1.10)1 (1.10)2 (1.10)3
LG3 20-26 Valuation of a Merger The managers of State Bank have been approached by City Bank about
a possible merger. State Bank is asking a price of $205 million to be purchased by City Bank. State
Bank currently has total cash flows of $15 million that are expected to grow at 1 percent annually for
the next two years. Managers are uncertain of the growth in State Bank’s cash flows in year 3.
Managers estimate that because of synergies the merged firm’s cash flows will increase by an
additional $1.5 million in the first year after the merger and these cash flows will grow by 5 percent
in years 2 and 3 following the merger. Managers have estimated that the present value of any
incremental cash flows received after year three is $158.75 million. The WACC for the merged firms
is 8 percent. Calculate State Bank’s minimum incremental cash flow needed in year 3 after the
merger such that City Bank would see this merger as a positive NPV project.
The incremental cash flows for the first three years after the merger are:
Year after merger 1 2 3
Cash flow from State Bank $15m(1.01) $15m(1.01)2 ?
This merger would be beneficial for the stockholders of the bidder firm if, in year 3 after the
merger, State Bank’s incremental cash flows in year 3 were $18.96 million.
LG5 20-27 Calculating the Probability of Bankruptcy A linear probability model you have
developed finds there are two factors influencing the past bankruptcy behavior of firms: the debt-
to-equity ratio and the sales-to-total assets ratio. Based on past bankruptcy experience, the linear
probability model is estimated as:
LG5 20-28 Calculating the Probability of Bankruptcy A linear probability model you have
developed finds there are two factors influencing the past bankruptcy behavior of firms: the debt-
to-equity ratio and the profit margin. Based on past bankruptcy experience, the linear probability
model is estimated as:
research it! Mergers and Acquisitions
Go to the Thomson Financial—Investment Banking and Capital Markets Group website at
http://dmi.thomsonreuters.com/DealsIntelligence and find the latest information available for
the dollar value of mergers and acquisition activity using the following steps. Click on
“QUARTERLY REVIEWS.” Under “MERGERS & ACQUISITIONS,” click on “Global M&A
Financial Advisory,” the most recent quarter. This will download a file on to your computer that
will contain the most recent information on merger and acquisition activity. What is the most
recent dollar value of global merger and acquisition activity undertaken? Who are the top
advisors on these merger and acquisition deals? How has the top advisor market share changed in
the last year?
integrated mini-case: Capital Funding in a Public Firm
Disaster Airlines is a firm in severe financial distress. The firm can no longer pay its bills on time
and it is far behind on payments to its banks and long-term debt holders. The firm has decided to
ether be purchased by another air carrier or liquidate its assets and close. The managers have
approached Altruistic Airlines about being acquired. After examining Disaster’s
financial statements, looking at the routes owned by Disaster, and looking at the condition of the
fixed assets, Altruistic Airlines has offered to pay the stockholders of Disaster Airlines $8 million
to be acquired. Disaster Airlines covers flights to both areas in which Altruistic already flies, but
also has routes in areas into which Altruistic is interested in expanding. As part of the analysis,
Altruistic determined that the additional cash flows resulting from the acquisition would total
$500,000 this year and would grow at a rate of 4 percent for the next three years. After this time
the cash flows would grow at a rate of two percent annually. The WACC of Altruistic Airlines
would be 8 percent after the merger.
If, instead, Disaster Airlines decides to liquidate its assets, it will pay off its debt and give
any remaining funds to the firm’s stockholders. Disaster Airlines’ balance sheet is listed as
follows.
Disaster Airlines, Inc.
Balance Sheet as of June 25, 2015
(in millions of dollars)
Assets Liabilities and Equity
Current assets: Current liabilities:
Cash and marketable Accrued wages (2,500 employees) $ 4
securities $ 63 Unpaid employee benefits 3
Accounts receivable 28 Unsecured customer deposits 6
Inventory 100 Accrued taxes 22
Total $ 191 Accounts payable 157
Notes payable to banks 211
Fixed assets: Total $ 403
Gross plant and
equipment $1,152 Long-term Debt:
Less: Depreciation 248 First mortgage $ 160
Net plant and Subordinate debentures 412
equipment $ 904 Total $ 572
Stockholders’ equity:
Common stock and
paid-in surplus $ 100
(100 million shares)
Retained earnings 20
Total $ 120
employee benefits were due in the six months prior to the filing for bankruptcy. The unsecured
customer deposits are for less than $900 each. Disaster Airlines has no property taxes past due.
The first mortgage is secured against the fixed assets of the firm. The debentures are subordinate
to the notes payable to banks. The liquidation of the firm’s current assets produced $186 million
and of the firm’s fixed assets produced $800 million for a total of only $986 million in funds to
distribute to the creditors and stockholders of the firm.
The administrative expenses associated with the bankruptcy totaled $1 million and
unpaid expenses incurred after the filing of the bankruptcy petition but before the trustee was
appointed totaled $5 million.
Show which method of dissolution, an acquisition by Altruistic Airlines or a liquidation
of assets, is more beneficial for the creditors and stockholders of Disaster Airlines and the
stockholders of Altruistic Airlines.
SOLUTION: The distribution of the $986 million of funds is as follows:
Proceeds from liquidation of assets: $986m
Administrative expenses associated with the bankruptcy proceedings 1m
Unpaid expenses incurred after the filing of the bankruptcy petition but
before the trustee is appointed 5m
Wages due to employees (2,500 employees) 4m
Unpaid employee benefit plan contributions 3m
Unsecured customer claims 6m
Taxes due to federal, state, and other governmental agencies 22m
Funds available for secured creditors: $945m
First mortgage 160m
Funds available for unsecured creditors: $785m
The remaining $785 million is distributed to the unsecured creditors on a pro rata basis, with
senior creditors paid in full before subordinate creditors. Thus,
Settlement Percent of claim
Unsecured Creditors Amount at 100% a
received
Accounts payable $157m $157m 100%
Notes payable to banks 211m 211m 100
Subordinate debentures 412m 412m 100
Total $780m $780m
a $785 million is available to pay $780 million in unsecured creditors. Thus, the pro rata settlement rate is $780m/
$780m = 100%.
The remaining $5 million ($785m – $780m) goes to the firm’s common stockholders.
Altruistic Airlines has offered the shareholders of Disaster Airlines $8 million to be acquired.
Thus, the shareholders of Disaster Airlines would be better to take this offer to be acquired rather
than liquidate the firm’s assets. The shareholders of Disaster would receive an additional $3
million ($8m – $5m) with the acquisition compared to the liquidation of assets.
The incremental cash flows for the first three years after the merger are:
Year after merger 1 2 3
Cash flows $0.50m(1.04)1 $0.50m(1.04)2
