Mini Case: 22- 19
Instead, the APV model breaks up the value of operations into two components:
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
finance the takeover. Thus, the debt involved has different costs, and hence cannot be
accounted for as a single cost in the WACC. The easiest solution is to explicitly
include the interest tax shield and use the APV.
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
– Gross investment in operating capital
= Free Cash Flow
OR:
NOPAT
– Investment in net operating capital
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
(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
at rsU; (3) calculate the horizon value of the tax shields as the present value of the
operations; (7) add any the value of any non-operating assets and subtract the value of
all debt to get the current equity value.
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
Mini Case: 22- 21
e. Conceptually, what is the appropriate discount rate to apply to the cash flows
using Lyons’ WACC, which is based on the costs of debt and equity after any change
in leverage.
To obtain the unlevered required rate of return we first need the levered required
rate of return. Note that rrf = 7% and rpm = 4%. Thus, the l division’s levered
required rate of return on equity is:
= 0.20(9%) + 0.80(12.2%) = 11.56%
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
g)Flow)(1Cash Free (2021
Tax Shield horizon value =
gr
g)Shield)(1Tax (2021
sU
=
06.01156.0
)06.1(264.3$
Mini Case: 22- 22
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website, in whole or in part.
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
Annual free cash flow $11.7 $10.5 $16.5 $ 20.7 $21.9
Unlevered horizon value 418.3
Total $11.7 $10.5 $16.5 $20.7 $440.2
Annual tax shield $2.0 $2.6 $2.6 $2.8 $3.3
Horizon value of tax shield 62.2
Total $2.0 $2.6 $2.6 $2.8 $65.5
The present value of this stream of cash flows at the unlevered cost of equity,
11.56%, is $45.5 million.
The value of Lyons’ equity is this value of operations less its current debt of $55
million, for an equity value of $289.4 million.
If another firm were valuing Lyons’, they would probably obtain an estimate
Mini Case: 22- 23
g. Assume that Lyons’ has 20 million shares outstanding. These shares are traded
Hager’s is $289.4 million, it appears that the merger would be beneficial to both sets
of stockholders. The difference, $289.4 – $220.0 = $69.4 million, is the added value
to be apportioned between the stockholders of both firms.
The offering range is from $11 per share to $289.4/20 = $14.47 per share. At $11,
all of the benefit of the merger goes to Hager’s shareholders, while at $14.47 all of
other potential suitors to consider Lyons’, and they could end up outbidding Hager’s.
Conversely, a high price, say $14, passes almost all of the gain to Lyons’
stockholders, and Hager’s managers should retain as much of the synergistic value as
possible for their own shareholders.
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’
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 2021 interest = Debt2020 x New interest rate
= $221.6 (10%) = $22.16 million
website, in whole or in part.
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?
prices of acquiring firms, on average, remain constant. Thus, one can conclude that
(1) acquisitions do create value, but (2) that shareholders of target firms reap virtually
all the benefits.
j. What method is used to account for mergers?
k. What merger-related activities are undertaken by investment bankers?
Answer: The investment banking community is involved with mergers in a number of
target companies, (4) helping to finance mergers, and (5) risk arbitrage—speculating
Mini Case: 22- 26
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
m. What are holding companies? What are their advantages and disadvantages?