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Answers and Solutions: 22 - 11
– 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
Cost of Goods Sold
$292.50
$336.70
$360.75
$390.00
$417.95
SGA
$45.00
$53.00
$60.00
$68.00
$73.00
EBIT
$112.50
$128.30
$134.25
$142.00
$152.05
Taxes on EBIT
(35%)
$39.38
$44.90
$46.99
$49.70
$53.22
NOPAT
$73.12
$83.40
$87.26
$92.30
$98.83
Total Operating Cap.
$800
$850.00
$930.00
$1,005
$1,075
$1,150
Inv. in Op. Capital
$50.00
$80.00
$75.00
$70.00
$75.00
FCF
$23.12
$3.40
$12.26
$22.30
$23.83
TSn = Interestn(Tax rate)
TS1 = 40(0.35) = 14.00, TS2 = 45(0.35) = 15.75, TS3 = 47(0.35) = 16.45,
TS4 = 52(0.35) = 18.20, TS5 = 54(0.35) = 18.90
c. Horizon value of tax shields = TS5(1+g)/(rsU – g)
Unlevered horizon value = FCF5(1+g)/(rsU – g)
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:
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)
Answers and Solutions: 22 - 14
website, in whole or in part.
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.
Mini Case: 22- 15
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.
Mini Case: 22- 16
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
(2) financial economies, which could include higher debt capacity, lower transactions
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
acquire a company with large accumulated tax losses, and immediately use those
losses to shelter its current and future income. Without the merger, the carry-
forwards might eventually be used, but their value would be higher if used now rather
customers, and managers. However, if a stock investor is concerned about earnings
variability, he or she can diversify more easily than can the firm. Why should firm a
and firm b merge to stabilize earnings when stockholders can merely purchase both
stocks and accomplish the same thing? Further, we know that well-diversified
shareholders are more concerned with a stock's market risk than its stand-alone risk,
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
buying out other oil companies than by exploratory drilling. However, the value of
an asset stems from its expected cash flows, not from its cost. Thus, paying $1
use debt financing to finance the acquisition. In general, defensive mergers appear to
be designed more for the benefit of managers than for that of the stockholders.
An increased desire to become globalized has resulted in many mergers. To
merge just to become international is not an economically justified reason for a
merger; however, increased globalization has led to increased economies of scale.
Thus, synergies often result--which is an economically justifiable reason for mergers.
Synergy appears to be the reason for this merger.
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
of shareholders. Then they issue statements to their stockholders recommending that
they agree to the merger. Of course, the shareholders of the target firm normally
their shares to the acquiring firm in exchange for cash, stock, bonds, or some
combination of the three. If 51 percent or more of the target firm's shareholders
tender their shares, then the merger will be completed over management's objection.
Mini Case: 22- 18
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
6. Calculate the unlevered firm value as the present value of the unlevered horizon
value and the FCFs at the unlevered cost of equity.
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
Free cash flow 11.7 10.5 16.5 20.7 21.94
Interest expense 5.0 6.5 6.5 7.0 8.2
Interest tax savings 2.0 2.6 2.6 2.8 3.264
