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6. a. Present value without the acquisition using the perpetual growth model =
$600,000/(0.14 – 0.06) = $7,500,000
b. ($600,000 + $100,000) / (0.14 – 0.06) = $8,750,000
c. $600,000 + $100,000 / (0.15 – 0.08) = $10,000,000
7.
Purchase
Tangible assets $15.0 million
Liabilities 6.0
Shareholder’s equity 10.0
8. There is likely to be a wealth transfer from old debt holders to equity holders. The former
will be worse off and the latter better off. The new company is assuming only $5 million of
the old debt, which with $20 million in equity value gives a debt-to-total-market-value ratio
9. With a 12 percent required return, the present value of $1 million forever is:
This is the value of the subsidiary to Lorzo-Perez. The investment of an additional $10
The offer of $10 million from Exson corporation is more than the value of the subsidiary to
10. After-tax profit increase associated with not being a public corporation =
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After-tax profit increase associated with improved management =
Maximum price that might be paid to take the company private =
11. Before-tax profits necessary to service annual principal payments on senior debt (in
Before-tax profits necessary to service principal payment at the end of year 6 on the junior
a. 12 percent prime rate.
Year (in thousands of dollars)
Debt service before taxes: 1 2 3 4 5 6
Senior debt principal 2,100 2,100 2,100 2,100 2,100 —
Interest (Prime + 2%) 980 784 588 392 196 —
Junior debt principal — — — — — 3,000
The debt can be properly serviced at this level of interest rate. It assumes, however, that the
company achieves the EBIT performance forecasted. If this does not occur, there could be a
shortfall because the margins of safety in the first several years and the last year are thin.
b. 12 percent prime rate going to 20 percent in year 2.
Year (in thousands of dollars)
Debt service before taxes: 1 2 3 4 5 6
Senior debt principal 2,100 2,100 2,100 2,100 2,100 —
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The enterprise would default in the second year if there were a sharp rise in the prime rate.
Moreover, the cushion in the third year would be very thin. The problem illustrates the risks
associated with high leverage. With business risk, the situation is even riskier than
illustrated.
Solutions to Appendix Problems:
12. Out of the $5 million, the trustee’s fee of $200,000 and the back taxes of $300,000 must
first be paid, leaving $4.5 million for distribution to creditors. The mortgage bondholders
would receive $1 million from the sale of the mortgaged equipment and become general
ORIGINAL CLAIM DISTRIBUTION
Trustee $ 200,000 $ 200,000
Property taxes 300,000 300,000
13.
EBIT $ 1,500,000
Divide: Debenture coverage ÷ 5
Debenture interest $ 300,000
Divide: Debenture coupon ÷ 0.10
Debentures $ 3,000,000
EBIT $ 1,500,000
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EBIT $ 1,500,000
Less: Total interest – 750,000
NIBT $ 750,000
Less: Taxes (40%) – 300,000
Net income before preferred dividends $ 450,000
Less: Preferred dividends 150,000
Capital structure:
Debentures $ 3,000,000
14.
a. Overall value of company = $800,000 × 5 = $4,000,000. From this amount, court costs
of $200,000 must be subtracted to give a total valuation of $3,800,000.
b. The bank loan and first-mortgage bonds are secured, so they simply will be continued
as they are. Given bankruptcy rules, accrued wages must be paid as a priority item.
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The maximum amount of capital notes that can be issued is
EBIT $ 800,000
Less: Bank loan interest 72,000
Divide by coverage ratio ÷ 4
Interest on long-term debt $ 182,000
Capital note interest $ 117,000
The maximum amount of preferred stock that can be issued according to the coverage
ratio is
EBIT $ 800,000
Less: Bank loan interest 72,000
Divide by coverage ratio ÷ 2
Divide by preferred rate ÷ 0.13
If these maximum amounts were employed, we would have the following for the
reorganized company (in thousands):
Current liabilities $1,300
Capital notes 780
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As this amount exceeds the total valuation of $3.8 million, it obviously is not feasible.
Something must give, and the most likely candidate is the preferred stock, owing to
Current liabilities $1,300,000
Common stock 1,140,000
c. Allocation of these securities in keeping with the rules of absolute priority would result
in the following:
OLD CLAIM NEW POSITION
Accounts payable $ 500,000 $ 500,000 same
780,000 Capital notes
$4,420,000 $3,800,000
Only the subordinated debenture holders receive securities different from what they
previously held. The common stockholders, as residual owners, receive less common stock
ownership than they had before.
SOLUTIONS TO SELF-CORRECTION PROBLEMS
1. a.
YABLONSKI YAWITZ
Earnings per share $2.00 $1.25
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b.
Surviving company earnings (in thousands) $5,000
There is an increase in earnings per share by virtue of acquiring a company with a lower
price/earnings ratio.
c. Market price per share: $2.0833 × 12 = $25.00
In the first instance, share price rises, from $24, due to the increase in earnings per
share. In the second case, share price falls owing to the decline in the price/earnings
2. With an exchange ratio of 1.5, Groove would issue 300,000 new shares of stock with a
market value of $28 × 300,000 = $8.4 million for the common stock of Tongue. This
PURCHASE
Current assets $25.0
Current liabilities $12.0
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3. a., b.
PRESENT VALUE OF
YEAR CASH FLOW INVESTMENT NET CASH FLOW NET CASH FLOW
(18%)
1 $2,300,000 $1,000,000 $1,300,000 $1,101,100
2 2,645,000 ” 1,645,000 1,181,110
3 3,041,750 ” 2,041,750 1,243,426
The maximum price that is justified is approximately $19.81 million. It should be noted that
these calculations use present value tables. To arrive at the discount rate for cash flows
4. a.
50,001 shares × $65 = $3,250,065
The total value of the economies to be realized is $1,500,000. Therefore, Passive
b. With a two-tier offer, there is a great incentive for individual shareholders to tender
early, thereby ensuring success for the acquiring firm. Collectively, Passive
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c. By instigating antitakeover amendments and devices, some incentives may be created
d.
50,001 shares × $65 = $3,250,065
This value is lower than the previous total market value of $5,500,000. Clearly,
shareholders would fare poorly if in the rush to tender shares, the offer were successful.
5. a. Shares owned by outsiders = 5 million × 0.79 = 3,950,000
Price to be offered = $20 × 1.40 = $28 per share
Annual EBIT to service debt:
Senior debt interest: $88,480,000 × 0.12 = $10,617,600
During the first five years, EBIT of $25 million will not be sufficient to service the debt.