FINANCIAL MANAGEMENT (FIN5FMA), SEMESTER 1, 2015 –

SOLUTIONS TO ASSIGNED QUESTIONS FOR TUTORIAL 10

Problems

Harrison Corporation is interested in acquiring Van Buren Corporation.

Assume that the risk-free rate of interest is 5% and the market risk premium is
6%.

Problem 21-1 (Valuation)

Van Buren currently expects to pay a year-end dividend of $2.00 per share (D 1 =
$2.00). Van Buren’s dividend is expected to grow at a constant rate of 5% a year,
and its beta is 0.90. What is the current price of Van Buren’s stock?

Cost of equity for Van Buren (rs) = rRF + RPM(b)

= 0.05 + (0.06)(0.90) = 0.1040 (10.40%)

Current price of Van Buren stock (P0) = $2.00 / (0.1040 – 0.05) = $37.04

Problem 21-2 (Merger valuation)

Harrison estimates that if it acquires Van Buren, the year-end dividend will
remain at $2.00 a share, but synergies will enable the dividend to grow at a
constant rate of 7% a year (instead of the current 5%). Harrison also plans to
increase the debt ratio of what would be its Van Buren subsidiary – the effect of
this would be to raise Van Buren’s beta to 1.10. What is the per-share value of
Van Buren to Harrison Corporation?

New cost of equity for Van Buren:

rs = rRF + RPM(b) = 0.05 + 0.06(1.10) = 0.1160 (11.60%)

Per-share value of Van Buren to Harrison = $2.00 / (0.1160 – 0.07) = $43.48

Problem 21-3 (Merger Bid)

On the basis of your answers to Problems 21-1 and 21-2, if Harrison were to
acquire Van Buren, what would be the range of possible prices it could bid for
each share of Van Buren common stock?

In terms of merger bid pricing, Harrison Corporation would have to pay at least what
the Van Buren shares are currently worth ($37.04), and Van Buren shareholders
would expect to receive some form of premium on top of the current price to
encourage them to sell their shares in the acquisition. Harrison Corporation would not
want to pay a higher price per share that what they think that Van Buren is worth to
them ($43.48), as they would destroy value (effectively undertake a negative-NPV
investment) if this was the case. Thus, the potential offer price range in an acquisition
bid would be between $37.04 and $43.38, and as close as possible to the current price
of $37.04 from the perspective of Harrison Corporation.
Problem 21-4 (Merger analysis)
Apilado Appliance Corporation is considering a merger with the Vaccaro
Vacuum Company. Vaccaro is a publicly traded company, and its current beta is
1.30. Vaccaro has been barely profitable, so it has paid an average of only 20%
in taxes during the last several years. In addition, it uses little debt, having a debt
ratio of just 25%. If the acquisition were made, Apilado would operate Vaccaro
as a separate, wholly-owned subsidiary. Apilado would pay taxes on a
consolidated basis, and the tax rate would therefore increase to 35%. Apilado
also would increase the debt capitalization in the Vaccaro subsidiary to 40% of
assets, which would increase its beta to 1.47. Apilado’s acquisition department
estimates that Vaccaro, if acquired, would produce the following net cash flows
to Apilado’s shareholders (in millions of dollars):

Year Net Cash Flows

1 $1.30
2 $1.50
3 $1.75
4 $2.00
5 and beyond Constant growth at 6%

These cash flows include all acquisition effects. Apilado’s cost of equity is 14%,
its beta is 1.00, and its cost of debt is 10%. The risk-free rate is 8%.
a. What discount rate should be used to discount the estimated cash flows?
(Hint: Use Apilado’s rs to determine the market risk premium.)

The appropriate discount rate to apply should reflect the riskiness of the cash flows to
equity investors. Thus, it is Vaccaro’s cost of equity, adjusted for leverage effects.

Since Apilado’s beta coefficient = 1.00, this implies that the market risk premium
(RPM) must = 6%. If the risk-free rate of return = 8%, then the market portfolio return
(RM) = 14%.

This can be used to determine the cost of equity to apply to the cash flows of Vaccaro
Vacuum Company:
rs = 0.08 + (0.06)(1.47) = 0.1682 (16.82%)

b. What is the dollar value of Vaccaro to Apilado?

CF1 = $1.30
CF2 = $1.50
CF3 = $1.75
CF4 = $2.00
CF5 = $2.00(1.06) = $2.12
Value of cash flows at the beginning of year 5, or end of year 4 (V 4) = $2.12 / (0.1682
– 0.06) = $19.59
Present value of Vaccaro cash flows (V 0) = $1.30/1.1682 + $1.50/(1.1682)2 +
$1.75/(1.1682)3 + $2.00/(1.1682)4 + $19.59/(1.1682)4 = $14.902 million
c. Vaccaro has 1.2 million common shares outstanding. What is the maximum
price per share that Apilado should offer for Vaccaro? If the tender offer is
accepted at this price, what will happen to Apilado’s stock price?

Maximum price (PMax) = $14.902 / 1.2 = $12.42 per share

If the tender offer was accepted at this price then Apilado is paying exactly what
Vaccaro is worth to them, and the acquisition would have a zero net present value. As
such, Apilado’s share price should remain at its current price, as no value is being
gained from the acquisition.