FIN 516

No. 1 – Acquisition Analysis

Brau Auto, a national  autoparts  chain, is considering purchasing a smaller chain, South Georgia Parts (SGP).  Brau’s  analysts project that the merger will result in the following incremental free cash flows, tax shields, and horizon values:

Years                                                 1          2          3          4

Free cash flow                                   $1        $3        $3        $7

Unlevered horizon value                                                      75

Tax shield                                          1         1         2         3

Horizon value of tax shield                                                  32

Assume that all cash flows occur at the end of the year.  SGP is currently financed with 30% debt at a rate of 10%.  The acquisition would be made immediately, and if it is undertaken, SGP would retain its current $15 million of debt and issue enough new debt to continue at the 30% target level.

The interest rate would remain the same.  SGP’s pre-merger beta is 2.0, and its post-merger tax rate would be 34%.  The risk-free rate is 8% and the market risk premium is 4%.  What is the value of SGP to Brau?

No. 2 – Acquisition Analysis

Magiclean Corporation is considering the acquisition of Dustvac Company.  Dustvac has a capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock.  Dustvac’s pre-merger beta is 1.36.  Magiclean’s beta is 1.02, and both it and Dustvac face a 40% tax rate.

Magiclean’s capital structure is 40% debt and 60% equity.  The free cash flows from Dustvac are estimated to be $3.0 million for each of the next 4 years and a horizon value of $10.0 million in Year 4.

Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4.  New debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%.  Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.

What Dustvac’s pre-merger WACC?

What discount rate should you use to discount Dustvac’s free cash flows and interest tax savings?

What is the value of Dustvac’s equity to Magiclean?

3-) Red Valley Breweries is considering an acquisition of Flagg Markets.  Flagg currently has a cost of equity of 10%; 25% of its financing is in the form of 6% debt, and the rest is the common equity.  Its  federal-plus-state tax rate is 40%.  After  the  acquisition,  Red Valley expects  Flagg to have the following  FCF’s and interest  payments for the next 3 years ( in millions):

Year  1                  Year 2                   Year 3

FCF                                      $10.00                  $20.00                  $25.00

Interest  expense                 28.00                 24.00                    20.28

After this, the free cash flows are  expected to grow at a constant rate of 5%, and the capital structure will stabilize at 35%  debt with an interest  rate of  7%.

A.     What is Flagg’s unlevered cost of equity?  What are its levered cost of equity and cost of capital for the post-horizon period?

4-) What is meant by “merger of equals”?