e. Conceptually, what is the appropriate discount rate to apply to the cash flows
developed in part c? What is your actual estimate of this discount rate?
Answer: As discussed above, the free cash flows, tax shields and horizon value should all
be discounted at the unlevered cost of equity. This cost should be calculated based on
To obtain the unlevered required rate of return we first need the levered required
rs(Lyons’ Lighting) = rrf + (rm – rrf)bLyons’ Lighting
f. What is the estimated horizon, or continuing, value of the acquisition; that is,
what is the estimated value of the L division’s cash flows beyond 2021? What is
Lyons’ value to Hager’s shareholders? Suppose another firm were evaluating
Lyons’ as an acquisition candidate. Would they obtain the same value? Explain.
Answer: The 2021 cash flow is $20.7 million, and it is expected to grow at a 6 percent constant
growth rate in 2021 and beyond. We will find the unlevered horizon value and the
horizon value of the tax shields:
Unlevered horizon value =
gr
g)Flow)(1Cash Free (2021
sU
=
06.01156.0
)06.1(94.21$
= $418.3 million.
Tax Shield horizon value =
gr
g)Shield)(1Tax (2021
sU
=
06.01156.0
)06.1(264.3$
To calculate the unlevered value of the firm, find the present value of the unlevered
horizon value and the free cash flows at the unlevered cost of equity (in millions of
dollars):
2017 2018 2019 2020 2021
The present value of these cash flows at the unlevered cost of equity, 11.56%, is
$298.9 million. This is the unlevered value of operations.
The value of the interest tax shields is calculated similarly:
2017 2018 2019 2020 2021
The present value of this stream of cash flows at the unlevered cost of equity,
Now, the value of Lyons’ operations is the sum of the unlevered value and the
value of the tax shields:
Value of operations = Unlevered value of operations + value of tax shields
If another firm were valuing Lyons’, they would probably obtain an estimate
g. Assume that Lyons’ has 20 million shares outstanding. These shares are traded
relatively infrequently, but the last trade, made several weeks ago, was at a price
of $11 per share. Should Hager’s make an offer for Lyons’? If so, how much
should it offer per share?
Answer: With a current price of $11 per share and 20 million shares outstanding, Lyons’
current market value is $11(20) = $220 million. Since Lyons’ expected value to
The offering range is from $11 per share to $289.4/20 = $14.47 per share. At $11,
As to the actual offering price, Hager’s should make the offer as low as possible,
yet acceptable to Lyons’ shareholders. A low initial offer, say $11.50 per share, would
Note that this discussion assumes that Lyons’ $11 price is a “fair,” equilibrium
h. How would the analysis be different if Hager’s intended to recapitalize Lyons’
with 40% debt costing 10% at the end of four years? This amounts to $221.6
million in debt as of the end of 2020.
Answer: The free cash flows and the unlevered cost of equity would be unchanged. Thus the
unlevered horizon value and the unlevered value of operations will remain the same.
If we assume that the interest payments in the first 4 years are unchanged, and the
intention is to use 40 percent debt costing 10 percent throughout 2021 and thereafter
at the horizon, then the horizon tax shield will be larger, as will the tax shield in 2019:
New Tax Shield horizon value =
gr
g)Shield)(1Tax 2021 (New
sU
=
06.01156.0
)06.1(864.8$
= $169.0 million.
The present value of this stream of cash flows at the unlevered cost of equity,
11.56%, is $110.5 million.
Since the unlevered value of operations doesn’t change, then the value of operations
is now the unlevered value of operations calculated earlier plus the new value of the
tax shields:
New Value of operations = Unlevered value of operations + value of tax shields
Less debt of $55 million leaves equity of $354.4 million. This is $65.0 million, or
i. There has been considerable research undertaken to determine whether mergers
really create value and, if so, how this value is shared between the parties
involved. What are the results of this research?
Answer: Most researchers agree that takeovers increase the wealth of the shareholders of
target firms, for otherwise they would not agree to the offer. However, there is a
debate as to whether mergers benefit the acquiring firm’s shareholders. The results of
j. What method is used to account for mergers?
Answer: Mergers must be accounted for using purchase accounting, in which the acquired
k. What merger-related activities are undertaken by investment bankers?
Answer: The investment banking community is involved with mergers in a number of
ways. Several of these activities are: (1) helping to arrange mergers, (2) aiding target
Hopefully, investment bankers are not giving kickbacks to company executives who
l. What are the major types of divestitures? What motivates firms to divest assets?
Answer: The three primary types of divestitures are (1) the sale of an operating unit to
another firm, (2) setting up the business to be divested as a separate corporation and
m. What are holding companies? What are their advantages and disadvantages?
Answer: Holding companies are corporations formed for the sole purpose of owning the
stocks of other companies. The advantages include the ability to control a company