Mini Case: 22- 13
MINI CASE
Hager’s Home Repair Company, a regional hardware chain, which specializes in “do–it–
yourself” materials and equipment rentals, is considering an acquisition of Lyon Lighting
(LL). Doug Zona, Hager’s treasurer and your boss, has been asked to place a value on the
target and he has enlisted your help.
LL has 20 million shares of stock trading at $12 per share. Security analysts estimate
LL’s beta to be 1.25. The risk-free rate is 5.5% and the market risk premium is 4%. LL’s
capital structure is 20% financed with debt at an 8% interest rate; any additional debt due
to the acquisition also will have an 8% rate. LL has a 25% federal-plus-state tax rate which
will not change due to the acquisition.
The following data incorporate expected synergies and required levels of total net
operating capital for LL should Hager’s complete the acquisition. The forecasted interest
expense includes the combined interest on LL’s existing debt and on new debt. After 2024,
all items are expected to grow at a constant 6% rate.
2019 2020 2021 2022 2023 2024
Net sales $150 $170 $186 $200 $212
Cost of goods sold $116 $128 $135 $148 $160
SGA $22 $26 $27 $28 $32
Total net operating capital $64 $75 $85 $93 $100 $106
Debta $30 $50 $52 $52 $53 $54
Note: aDebt is added on the first day of the year, so the 2019 debt is LL’s debt prior to the
acquisition.
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- 14
a. Several reasons have been proposed to justify mergers. Among the more
prominent are (1) synergy, (2) tax considerations, (3) breakup value, (4) risk
reduction through diversification, (4) purchase of assets at below-replacement
cost, and (5) managerial incentives. In general, which of the reasons are
economically justifiable? Which are not?
Answer:
Synergy occurs when the value of the combined firm exceeds the sum of the values
of the firms taken separately.
A highly profitable could acquire a company with large accumulated tax losses or
accumulated interest expenses limited by the TCJA, and immediately use those losses
to shelter its current and future income. Without the merger, the target might be able to
eventually use the carry-forwards, but their value would be higher if used now rather
than in the future.
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Diversification through a merger might stabilize earnings, which is certainly
beneficial to a firm’s employees, suppliers, 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, and higher earnings instability does not necessarily
translate into higher market risk.
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
another firm (the target). In most cases, the action is initiated by the acquiring firm,
but in some situations the target may initiate the merger. The managements of both
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:
d. Why can’t we estimate LL’s value to Hager’s by discount the FCFs at the WACC?
What method is appropriate? Use the projections and other data to determine the
LL division’s free cash flows and interest tax savings for 2020 through 2024.
Notice that the LL division’s sales are expected to grow rapidly during the first
years before leveling off at a sustainable long-term growth rate.
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).
Mini Case: 22- 17
2019
2020
2021
2022
2023
2024
Total net operating capital
$64
$75
$85
$93
$100
$106
Investment in operating capital
$11
$10
$8
$7
$6
Free Cash Flow
-$2
$2
$10
$11
$9
2019
Debt
$30
$50.00
$52.00
$52.00
$53.00
$54.00
Interest expense
$4.00
$4.16
$4.16
$4.24
$4.32
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
Mini Case: 22- 18
NOPAT
+ Depreciation
= Operating Cash Flow
– Gross investment in operating capital
= Free Cash Flow
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
at rsU; (3) calculate the horizon value of the tax shields as the present value of the
interest tax shields after the horizon discounted at rsU; (4) calculate the value of the
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e. Conceptually, what is the appropriate discount rate to apply to the cash flows
developed in part d? 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 the
f. What is the estimated unlevered horizon value? What is the current unlevered
value operating value? What is the horizon value of the interest tax savings? What
is the current value of the interest tax savings? What is the current total value of
the acquisition to Hager’s shareholders? Suppose another firm were evaluating
Lyon Lighting as an acquisition candidate. Would they obtain the same value?
Explain.
Answer: The 2024 cash flow is $9 million, and it is expected to grow at a 6 percent constant
growth rate in 2024 and beyond. We will find the unlevered horizon value and the
horizon value of the tax shields:
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The present value of these cash flows at the unlevered cost of equity, 10%, is
$168.539 million. This is the unlevered value of operations.
The value of the interest tax shields is calculated similarly:
Now, the value of LL’s 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
= $168.539 million + $21.175 million
= $190.254 million
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g. Assume that Lyon Lighting has 10 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? If so, how much should
it offer per share?
Answer: With a current price of $11 per share and 20 million shares outstanding, LL’s
current market value is $11(20) = $220 million. Since LL’s expected value to 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
Mini Case: 22- 22
h. 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
i. What method is used to account for mergers?
Answer: Mergers must be accounted for using purchase accounting, in which the acquired
j. 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
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k. 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
l. What are holding companies? What are their advantages and disadvantages?
Answer: Holding companies are corporations formed for the sole purpose of owning the