CHAPTER 21
THE EAST COAST-WEST COAST
SAILBOATS MERGER
1. As with any other merger analysis, we need to examine the present value of the incremental cash flows.
The cash flow today from the acquisition is the acquisition costs plus the dividends paid today, or:
Acquisition of West Coast
–$211,000,000
Dividends from West Coast
57,000,000
Total
–$154,000,000
Using the information provided, the cash flows to East Coast Yachts from acquiring West Coast
Sailboats for the next five years will be:
Year 1
Year 2
Year 4
Year 5
Dividends from West Coast
$14,822,400
$5,171,200
$15,612,000
$21,882,000
Tax-loss carryforwards
9,600,000
Terminal value of equity
345,000,000
Terminal value of debt
–115,000,000
Total
$14,822,400
$14,771,200
$15,612,000
$481,882,000
To discount the cash flows from the merger, we must discount each cash flow at the appropriate discount
rate. The additional cash flows from the tax-loss carry forwards and the proposed level of debt should be
discounted at the cost of debt because they are determined with very little uncertainty.
The terminal value of the company is subject to normal business risk and must be discounted at a normal
rate. The current weight of debt and weight of equity in West Coast’s capital structure is:
XD = .50/(1 + .50)
The beta for West Coast’s debt is:
D = (.08 – .06)/(.13 – .06)
D = .29
Now, we can calculate the required return for normal operations of West Coast, which is:
E(RWC) = .06 + .96(.13 – .06)
E(RWC) = .1273, or 12.73%
To find the discount rate for dividends, we need to find the new beta of equity for the merged West Coast.
The new debt-equity ratio is 1, which implies a weight of debt and a weight of equity equal to 50 percent.
The new beta for equity must be:
E(RDiv) = .06 + 1.59(.13 – .06)
E(RDiv) = .1713, or 17.13%
Now we can find the present value of the future cash flows. The present value of each year’s cash flows,
along with the appropriate discount rate for each cash flow is:
Discount
rate
Year 1
Year 2
Year 3
Year 4
Year 5
Dividends
17.13%
$12,654,297
$3,769,036
$6,981,791
$8,293,475
$9,923,948
Tax-loss
8%
8,230,453
7,620,790
TV of equity
12.73%
189,477,372
TV of debt
8%
–78,267,068
Total
$12,654,297
$11,999,489
$14,602,580
$8,293,475
$121,134,253
And the NPV of the acquisition is:
NPV = –$154,000,000 + 12,654,297 + 11,999,489 + 14,602,580 + 8,293,475 + 121,134,253
NPV = $14,684,094.10
2. Since the acquisition is a positive NPV project, the most East Coast would offer is to increase the current
cash offer by the current NPV, or:
Highest offer = $211,000,000 + 14,684,094.10
Highest offer = $225,684,094.10
need to determine the new share price under the original cash offer. The new share price of East Coast
after the merger will be:
PNew = [$94 × 6,900,000 + $14,684,094.10]/6,900,000
PNew = $96.13
CHAPTER 21 C-3
So, the exchange ratio which would make the cash offer and share offer equivalent is:
Exchange ratio = $68.75/$96.13
Exchange ratio = .7152
4. The highest exchange ratio East Coast would accept is an exchange ratio that results in a zero NPV
acquisition. This implies the share price of East Coast remains unchanged after the merger, so the
exchange ratio is: