978-1305632295 Chapter 22 Solution Manual Part 2

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22-6 a. BCC’s unlevered cost of equity depends on its pre-merger cost of equity and its

pre-merger capital structure:

b. The free cash flows are NOPAT – investment in net operating capital = (Sales – CGS

– selling expenses)(1-T) – investment in net operating capital. CGS is 65% of sales:

2016 2017 2018 2019 2020 2021

Net sales $450.00 $518.00 $555.00 $600.00 $643.00

(35%)

NOPAT $73.12 $83.40 $87.26 $92.30 $98.83

TSn = Interestn(Tax rate)

c. Horizon value of tax shields = TS5(1+g)/(rsU – g)

Unlevered horizon value = FCF5(1+g)/(rsU – g)

Answers and Solutions: 22 – 1

website, in whole or in part.

d. Value of tax shields = PV of tax shields and the PV of the horizon value of the tax

shields at rsU.

The unlevered value of operations = PV of the FCFs and the PV of the unlevered

horizon value at rsU. The cash flows for both are summarized below:

2017 2018 2019 2020 2021

1. Tax shield $14.00 $15.75 $16.45 $18.20 $18.90

2. TSHV $510.68

The NPV of the TS yearly values and horizon value (shown in row 3) when

discounted at 10.96% is $364.30, which is the value of the tax shields.

The NPV of the FCF yearly values and horizon value (shown in row 6) is

The sum of the value of the tax shields and the unlevered value of operations is

the value of operations: 364.30 + 444.27 = $808.57.

Less the value of debt, $300, is the value of equity:

Answers and Solutions: 22 – 2

website, in whole or in part.

Although we don’t need this calculation for the valuation, after the merger, BCC will

have 50 percent of debt costing 10%, so its levered cost of equity and WACC will be:

rsL = rsU + (rsU –rd)(D/S)

WACC = wdrd(1-T) + wsrs

SOLUTION TO SPREADSHEET PROBLEMS

22-7 The detailed solution for the spreadsheet problem, Ch22 P07 Build a Model

Solution.xlsx, is available on the textbook’s Web site.

Answers and Solutions: 22 – 3

website, in whole or in part.

MINI CASE

Hager’s Home Repair Company, a regional hardware chain that specializes in

“do-it-yourself” materials and equipment rentals, is cash rich because of several

consecutive good years. One of the alternative uses for the excess funds is an acquisition.

Doug Zona, Hager’s treasurer and your boss, has been asked to place a value on a potential

target, Lyons’ Lighting (LL), a chain that operates in several adjacent states, and he has

enlisted your help.

The table below indicates Zona’s estimates of LL’s earnings potential if it came

under Hager’s management (in millions of dollars). The interest expense listed here

includes the interest (1) on LL’s existing debt, which is $55 million at a rate of 9 percent,

and (2) on new debt expected to be issued over time to help finance expansion within the

new “L division,” the code name given to the target firm. If acquired, LL will face a 40

percent tax rate.

Security analysts estimate LL’s beta to be 1.3. The acquisition would not change

Lyons’ capital structure, which is 20 percent debt. Zona realizes that Lyons’ Lighting’s

business plan also requires certain levels of operating capital and that the annual

investment could be significant. The required levels of total net operating capital are listed

below.

Zona estimates the risk-free rate to be 7 percent and the market risk premium to be

4 percent. He also estimates that free cash flows after 2021 will grow at a constant rate of 6

percent. Following are projections for sales and other items.

2016 2017 2018 2019 2020 2021

Net sales $60.00 $90.00 $112.50 $127.50 $139.70

Cost of goods sold (60%) 36.00 54.00 67.50 76.50 83.80

Selling/administrative expense 4.50 6.00 7.50 9.00 11.00

Interest expense 5.00 6.50 6.50 7.00 8.16

Total net operating capital 150.00 150.00 157.50 163.50 168.00 173.0

Hager’s management is new to the merger game, so Zona has been asked to answer some

basic questions about mergers as well as to perform the merger analysis. To structure the

task, Zona has developed the following questions, which you must answer and then defend

to Hager’s board.

Answers and Solutions: 22 – 4

website, in whole or in part.

a. Several reasons have been proposed to justify mergers. Among the more

prominent are (1) tax considerations, (2) risk reduction, (3) control, (4) purchase

of assets at below-replacement cost, (5) synergy, and (6) globalization. In

general, which of the reasons are economically justifiable? Which are not?

Which fit the situation at hand? Explain.

Answer: The economically justifiable rationales for mergers are synergy and tax

consequences. Synergy occurs when the value of the combined firm exceeds the sum

A synergistic merger creates value, which must be apportioned between the

stockholders of the merging companies. Synergy can arise from four sources: (1)

Another valid rationale behind mergers is tax considerations. For example, a firm

which is highly profitable and consequently in the highest corporate tax bracket could

The motives that are generally less supportable on economic grounds are risk

Stabilization of earnings is certainly beneficial to a firm’s employees, suppliers,

customers, and managers. However, if a stock investor is concerned about earnings

Answers and Solutions: 22 – 5

website, in whole or in part.

Sometimes a firm will be touted as a possible acquisition candidate because the

replacement value of its assets is considerably higher than its market value. For

example, in the early 1980s, oil companies could acquire reserves more cheaply by

In recent years, many hostile takeovers have occurred. To keep their companies

independent, and also to protect their jobs, managers sometimes engineer defensive

An increased desire to become globalized has resulted in many mergers. To

b. Briefly describe the differences between a hostile merger and a friendly merger.

Answer: In a friendly merger, the management of one firm (the acquirer) agrees to buy

another firm (the target). In most cases, the action is initiated by the acquiring firm,

If a target firm’s management resists the merger, then the acquiring firm’s

advances are said to be hostile rather than friendly. In this case, the acquirer, if it

Answers and Solutions: 22 – 6

website, in whole or in part.

c. What are the steps in valuing a merger using the compressed APV approach?

Answer: When the capital structure is changing rapidly, as in many mergers, the WACC

changes from year-to-year and it is difficult to apply the corporate valuation model in

these cases. The compressed APV model works better when the capital structure is

changing. The steps are:

1. Project FCFt ,TSt until the target is at its target capital structure for one year and is

expected to grow thereafter at a constant growth rate.

2. Project the horizon growth rate.

d. Use the data developed in the table to construct the L division’s free cash flows

for 2017 through 2021. Why are we identifying interest expense separately since

it is not normally included in calculating free cash flow or in a capital budgeting

cash flow analysis? Why is investment in net operating capital included when

calculating free cash flow?

Answer: The easiest approach here is to calculate the free cash flows for the L division,

assuming that the acquisition is made (in millions of dollars).

2016 2017 2018 2019 2020 2021

Net sales $60.0 $90.0 $112.5 $127.5 $139.70

Cost of goods sold (60%) 36.0 54.0 67.5 76.5 83.80

Selling/admin. Expenses 4.5 6.0 7.5 9.0 11.0

EBIT 19.5 30.0 37.5 42.0 44.9

Answers and Solutions: 22 – 7

website, in whole or in part.

Note that these free cash flows are identical to what you would construct to use

the corporate valuation model or to use standard capital budgeting procedures, except

Voperations = Vunlevered + Vtax shield .

The free cash flows and interest tax savings are discounted separately at the unlevered

cost of equity. This is more convenient to use than the corporate value model because

the unlevered cost of equity can be used even when the capital structure is changing.

Also, in straight capital budgeting and the simplest application of the corporate

value model all debt involved is new debt, which is issued to fund the asset additions.

In regards to retentions, all of the cash flows from an individual project are

available for use throughout the firm, since capital expenditures are explicitly

NOPAT

+ Depreciation

= Operating Cash Flow

– Gross investment in operating capital

NOPAT

– Investment in net operating capital

= Free Cash Flow

Where investment in net operating capital

= Gross investment in operating capital – Depreciation.

The interest tax savings are cash flows that are also available to pay interest,

principal, or for other use within the firm. In the corporate valuation model (which

Answers and Solutions: 22 – 8

website, in whole or in part.

The steps to apply the APV model are:

(1) Calculate the unlevered cost of equity, rsU, using the pre-merger levered cost of

equity and the pre-merger capital structure; (2) calculate the horizon value of the

unlevered firm as the present value of the free cash flows after the horizon discounted

Note that the Extension to this chapter discusses how the final interest expense

projections are made and shows that in many cases, and in this case, the corporate

Answers and Solutions: 22 – 9

website, in whole or in part.