Ross 10/e

MERGER & ACQUISITION

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Plant, Inc., is considering making an offer to purchase Palmer Corp. Plant’s vice president of
finance has collected the following information:

Plant Palmer
Price–earnings ratio 14.5 10
Shares outstanding 1,500,000 750,000
Plant also knows that securities
Earnings $4,200,000 $960,000
analysts expect the earnings
Dividends 1,050,000 470,000
and dividends of Palmer to
grow at a constant rate of 4% each year. Plant management believes that the acquisition of
Palmer will provide the firm with some economies of scale that will increase this growth rate
to 6% per year.

REQUIRED:

a) What is the value of Palmer to Plant?

b) What would Plant’s gain be from this acquisition?
c) If Plant were to offer $20 in cash for each share of Palmer, what would the NPV of the
acquisition be? .
d) What is the most Plant should be willing to pay in cash per share for the stock of Palmer?
e) If Plant were to offer 225,000 of its shares in exchange for the outstanding stock of
Palmer, what would the NPV be?
f) Should the acquisition be attempted? If so, should it be as in (c) or as in (e)?
g) Plant’s outside financial consultants think that the 6% growth rate is too optimistic and a
5% rate is more realistic. How does this change your previous answers?

MERGER & ACQUISITION

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Fly-By-Night Couriers is analyzing the possible acquisition of Flash-in-the-Pan Restaurant.

Neither firm has debt. The forecasts of Fly-By-Night show that the purchase would increase
its annual after-tax cash flow by $390,000 indefinitely. The current market value of Flash-
in-the-Pan is $7 million. The current market value of Fly-By-Night is $22 million. The
appropriate discount rate for the incremental cash flows is 8%. Fly-By-Night is trying to
decide whether it would offer 30% of its stock or $9 million in cash to Flash-in-the-Pan.
REQUIRED:

a) What is the Synergy from the merger?

b) What is the Value of Target (Flash-in-the-Pan) to Acquirer (Fly-By-Night)?
c) What is the Cost to Fly-By-Night of Each alternative?
d) What is the NPV to Fly-By-Night of Each alternative?
e) What alternative should Fly-By-Night use?

Merger & Acquisition

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The shareholders of Flannery Company have voted in favor of a buyout offer from Stultz
Corporation. Information about each firm is given here:

Flannery Stultz
Price–earnings ratio 6.35 12.70
Shares outstanding 73,000 146,000
Earnings $230,000 $690,000

Flannery’s shareholders will receive one share of Stultz stock for every three shares they hold
in Flannery.
REQUIRED:
a) What will the EPS of Stultz be after the merger? What will the PE ratio be if the NPV
of the acquisition is zero?
b) What must Stultz feel is the value of the synergy between these two firms? Explain
how your answer can be reconciled with the decision to go ahead with the takeover.

Bond
Charles River Associates is considering whether to call either of the two perpetual bond
issues the company currently has outstanding. If the bond is called, it will be refunded, that is,
a new bond issue will be made with a lower coupon rate. The proceeds from the new bond
issue will be used to repurchase one of the existing bond issues. The information about the
two currently outstanding bond issues is:
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Bond A Bond B
Coupon rate 7.00% 8.00%
Value outstanding $125,000,000 $132,000,000 The corporate
Call premium 7.50% 8.50% tax rate is 35%.
Transaction cost of refunding $11,500,000 $13,000,000
Current YTM 6.25% 7.10% REQUIRED:
What is the NPV
of the refunding for each bond? Which, if either, bond should the company refinance?
Assume the call premium is tax deductible.

CAPITAL STRUCTURE

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure.
ABC is all equity financed with $750,000 in stock. XYZ uses both stock and perpetual debt;
its stock is worth $375,000 and the interest rate on its debt is 8 %. Both firms expect EBIT to
be $86,000. Ignore taxes.
REQUIRED:
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a) Richard owns $30,000 worth of XYZ’s stock. What rate of return is he expecting?
b) Show how Richard could generate exactly the same cash flows and rate of return by
investing in ABC and using homemade leverage.
c) What is the cost of equity for ABC? What is it for XYZ?
d) What is the WACC for ABC? For XYZ? What principle have you illustrated?

CAPITAL STRUCTURE

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure.
ABC is all-equity financed with $600,000 in stock. XYZ uses both stock and perpetual debt;
its stock is worth $300,000 and the interest rate on its debt is 10 percent. Both firms expect
EBIT to be $73,000. Ignore taxes.

REQUIRED:
a) Rico owns $30,000 worth of XYZ's stock. What rate of return is she expecting?
b) Show how Rico could generate exactly the same cash flows and rate of return by
investing in ABC and using homemade leverage.
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c) What is the cost of equity for ABC? What is it for XYZ?

d) What is the WACC for ABC? For XYZ? What principle have you illustrated?

CAPITAL STRUCTURE
The Veblen Company and the Knight Company are identical in every respect except that
Veblen is not levered. The market value of Knight Company’s 6% bonds is Tk.1.4 million.
Financial information for the two firms appears here. All earnings streams are perpetuities.
Neither firm pays taxes. Both firms distribute all earnings available to common stockholders
immediately.

Veblen Knight
Projected Operating Income Tk.550,000 Tk.550,000
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Year End Interest on Debt — 84,000

Market Value of Stock/Equity 4,300,000 3,140,000
Market Value of Debt — 1,400,000

REQUIRED:

a) An investor who can borrow at 6% per year wishes to purchase 5% of Knight’s equity.
Can he increase his money return by purchasing 5% of Veblen’s equity if he borrows so
that the initial net costs of the two strategies are the same?
b) Given the two investment strategies in (a), which will investors choose? When will this
process cease?
-ICAB Adopted

Capital Structure
Weston Industries has a debt–equity ratio of 1.5. Its WACC is 11%, and its cost of debt is
7%. The corporate tax rate is 35%.
REQUIRED:
a) What is Weston’s cost of equity capital?
b) What is Weston’s unlevered cost of equity capital?
c) What would the cost of equity be if the debt–equity ratio was 2? What if it were 1.0?
What if it were zero?
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Capital Structure
Shadow Corp. has no debt but can borrow at 8%. The firm’s WACC is currently 11%, and
the tax rate is 35%.
REQUIRED:
a) What is Shadow’s cost of equity?
b) If the firm converts to 25% debt, what will it’s cost of equity be?
c) If the firm converts to 50% debt, what will it’s cost of equity be?
d) What is Shadow’s WACC in part (b)? In part (c)?

Capital Structure
Acetate, Inc., has equity with a market value of $23 million and debt with a market value of
$7 million. Treasury bills that mature in one-year yield 5% per year, and the expected return
on the market portfolio is 12%. The beta of Acetate’s equity is 1.15. The firm pays no taxes.
REQUIRED:
a) What is Acetate’s debt–equity ratio?
b) What is the firm’s weighted average cost of capital?
c) What is the cost of capital for an otherwise identical all-equity firm?

Capital Structure
Williamson, Inc., has a debt–equity ratio of 2.5. The firm’s weighted average cost of capital
is 10%, and its pretax cost of debt is 6%. Williamson is subject to a corporate tax rate of 35%.
REQUIRED:
a) What is Williamson’s cost of equity capital?
b) What is Williamson’s unlevered cost of equity capital
c) What would Williamson’s weighted average cost of capital be if the firm’s debt–
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Capital Structure
Bolero, Inc., has compiled the following information on its financing costs:

Type of Financing Book Value Market Value Cost

Short-term debt $10,000,000 $11,000,000 4.1%
Long-term debt 3,000,000 3,000,000 7.2%
Common stock 6,000,000 26,000,000 13.8%
Total $19,000,000 $40,000,000 -
The company is in the 35% tax bracket and has a target debt–equity ratio of 60%. The target
short-term debt/long-term debt ratio is 20%.
REQUIRED:

a) What is the company’s Weighted Average Cost of Capital (WACC) using: -

i) Book Value Weights?
ii) Market Value Weights?
iii) Target Capital Structure Weights?
b) What is the difference between WACCs? Which is the correct WACC to use for project
evaluation?
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Capital Structure
If Wild Widgets, Inc., were an all-equity company, it would have a beta of .85. The company
has a target debt–equity ratio of .40. The expected return on the market portfolio is 11%, and
Treasury bills currently yield 4% The company has one bond issue outstanding that matures
in 20 years and has a coupon rate of 7% The bond currently sells for $1,080. The corporate
tax rate is 34%.
REQUIRED:
a) What is the company’s cost of debt?
b) What is the company’s cost of equity?
c) What is the company’s weighted average cost of capital?

Capital Structure
North Pole Fishing Equipment Corporation and South Pole Fishing Equipment Corporation
would have identical equity betas of 1.10 if both were all equity financed. The market value
information for each company is shown here:
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North Pole South Pole

Debt $2,900,000 $3,800,000
Equity $3,800,000 $2,900,000

The expected return on the market portfolio is 10.9%, and the risk-free rate is 3.2%. Both
companies are subject to a corporate tax rate of 35%. Assume the beta of debt is zero.
REQURED:
a) What is the equity beta of each of the two companies?
b) What is the required rate of return on each of the two companies’ equity?

Capital Structure
Daniel Kaffe, CFO of Kendrick Enterprises, is evaluating a 10-year, 8% loan with gross
proceeds of $5,850,000. The interest payments on the loan will be made annually. Flotation
costs are estimated to be 2.5% of gross proceeds and will be amortized using a straight-line
schedule over the 10-year life of the loan. The company has a tax rate of 40%, and the loan
will not increase the risk of financial distress for the company.
REQURED:
a) Calculate the net present value of the loan excluding flotation costs.
b) Calculate the net present value of the loan including flotation costs.

Dividend Policy
Stock Splits and Stock Dividends Roll Corporation (RC) currently has 330,000 shares of
stock outstanding that sell for $64 per share. Assuming no market imperfections or tax
effects exist, what will the share price be after:
a) RC has a five-for-three stock split?
b) RC has a 15% stock dividend?
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c) RC has a 42.5% stock dividend?

d) RC has a four-for-seven reverse stock split?
REQUIRED:
Determine the new number of shares outstanding in parts (a) through (d).

Dividend Policy
The net income of Novis Corporation is $85,000. The company has 25,000 outstanding
shares and a 100% payout policy. The expected value of the firm one year from now is
$1,725,000. The appropriate discount rate for Novis is 12%, and the dividend tax rate is zero.
REQUIRED:
a) What is the current value of the firm assuming the current dividend has not yet been paid?
b) What is the ex-dividend price of Novis’s stock if the board follows its current policy?
c) At the dividend declaration meeting, several board members claimed that the dividend is
too meager and is probably depressing Novis’s price. They proposed that Novis sell
enough new shares to finance a $4.60 dividend.
i) Comment on the claim that the low dividend is depressing the stock price. Support
your argument with calculations.
ii) If the proposal is adopted, at what price will the new shares sell? How many will
be sold?

Dividend Policy
Gibson Co. has a current period cash flow of $1.1 million and pays no dividends. The present
value of the company’s future cash flows is $15 million. The company is entirely financed
with equity and has 600,000 shares outstanding. Assume the dividend tax rate is zero.
REQUIRED:
a) What is the share price of the Gibson stock?
b) Suppose the board of directors of Gibson Co. announces its plan to pay out 50% of its
current cash flow as cash dividends to its shareholders. How can Jeff Miller, who
owns 1,000 shares of Gibson stock, achieve a zero payout policy on his own?
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Leasing
High electricity costs have made Farmer Corporation’s chicken plucking machine
economically worthless. Only two machines are available to replace it. The International
Plucking Machine (IPM) model is available only on a lease basis. The lease payments will be
$65,000 for five years, due at the beginning of each year. This machine will save Farmer
$15,000 per year through reductions in electricity costs. As an alternative, Farmer can
purchase a more energy efficient machine from Basic Machine Corporation (BMC) for
$330,000. This machine will save $25,000 per year in electricity costs. A local bank has
offered to finance the machine with a $330,000 loan. The interest rate on the loan will be
10% on the remaining balance and will require five annual principal payments of $66,000.
Farmer has a target debt-to-asset ratio of 67%. Farmer is in the 34% tax bracket. After five
years, both machines will be worthless. The machines will be depreciated on a straight-line
basis.
REQUIRED:
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a) Should Farmer lease the IPM machine or purchase the more efficient BMC
machine?
b) Does your answer depend on the form of financing for direct purchase?
c) How much debt is displaced by this lease?

Dividends Policy
The Mann Company belongs to a risk class for which the appropriate discount rate is 10%.
Mann currently has 220,000 outstanding shares selling at $110 each. The firm is
contemplating the declaration of a $4 dividend at the end of the fiscal year that just began.
Assume there are no taxes on dividends. Answer the following questions based on the Miller
and Modigliani (MM) model, which is discussed in the text.
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REQUIRED:
a) What will be the price of the stock on the ex-dividend date if the dividend is declared?
b) What will be the price of the stock at the end of the year if the dividend is not
declared?
c) If Mann makes $4.5 million of new investments at the beginning of the period, earns
net income of $1.9 million, and pays the dividend at the end of the year, how many
shares of new stock must the firm issue to meet its funding needs?
d) Is it realistic to use the MM model in the real world to value stock? Why or why not?
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Cost of Capital
1) Calculating Cost of Debt Shanken Corp. issued a 30-year, 6.2% semiannual bond 7 years ago.
The bond currently sells for 108% of its face value. The company’s tax rate is 35%.

Required:

a) What is the pretax cost of debt?

b) What is the after tax cost of debt?
c) Which is more relevant, the pretax or the after tax cost of debt? Why?

2) Filer Manufacturing has 8.3 million shares of common stock outstanding. The current share price
is $53, and the book value per share is $4. Filer Manufacturing also has two bond issues
outstanding. The first bond issue has a face value of $70 million and a coupon rate of 7% and sells
for 108.3% of par. The second issue has a face value of $60 million and a coupon rate of 7.5%
and sells for 108.9% of par. The first issue matures in 8 years, the second in 27 years.

Required:

a) What are Filer’s capital structure weights on a book value basis?

b) What are Filer’s capital structure weights on a market value basis?
c) Which are more relevant, the book or market value weights? Why?
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3) SML and WACC An all-equity firm is considering the following projects:

Project Beta IRR

W .80 9.4%
X .95 10.9%
Y 1.15 13.0%
Z 1.45 14.2%

The T-bill rate is 3.5%, and the expected return on the market is 11%.

Required:

a) Which projects have a higher expected return than the firm’s 11% cost of capital?
b) Which projects should be accepted?
c) Which projects would be incorrectly accepted or rejected if the firm’s overall cost of capital
was used as a hurdle rate?

4) Floyd Industries stock has a beta of 1.3. The company just paid a dividend of $.95, and the
dividends are expected to grow at 4.5% per year. The expected return on the market is 11%, and
Treasury bills are yielding 4.3%. The most recent stock price for Floyd is $64.

Required:

a) Calculate the cost of equity using the DDM method.

b) Calculate the cost of equity using the SML method.
c) Why do you think your estimates in (a) and (b) are so different?

Merger & Acquisition

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Consider the following pre-merger information about firm A and firm B:

Firm-A Firm-B
Total earnings $2,100 $700
Shares outstanding 900 300
Price per share $60 $17

Assume that firm A acquires firm B via an exchange of equity at a price of $18 for each share
of B’s equity. Both A and B have no debt outstanding.
REQUIRED:

a) What will the earnings per share (EPS) of firm A be after the merger?
b) What will firm A’s price per share be after the merger if the market incorrectly analyses
this reported earnings growth (that is, the price–earnings ratio does not change)?
c) What will the price–earnings ratio of the post-merger firm be if the market correctly
analyses the transaction?
d) If there are no synergy gains, what will the share price of A be after the merger? What
will the price–earnings ratio be? What does your answer for the share price tell you about
the amount A bid for B? Was it too high? Too low? Explain.
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Merger & Acquisition

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Bentley plc and Rolls Manufacturing are considering a merger. The possible states of the
economy and each company’s value in that state are shown here:

State Probability Bentley Rolls

Boom 0.70 $2,90,000 $260,000
Recession 0.30 $110,000 $80,000
Bentley currently has a bond issue outstanding with a face value of $1,25,000. Rolls is an all-
equity company.
REQUIRED:

a) What is the value of each company before the merger?

b) What are the values of each company’s debt and equity before the merger?
c) If the companies continue to operate separately, what are the total value of the companies,
the total value of the equity, and the total value of the debt?
d) What would be the value of the merged company? What would be the value of the
merged company’s debt and equity?
e) Is there a transfer of wealth in this case? Why?
f) Suppose that the face value of Bentley’s debt was $90,000. Would this affect the transfer
of wealth?
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COST OF CAPITAL
Filer Manufacturing has 8.3 million shares of common stock outstanding. The current share
price is $53, and the book value per share is $4. Filer Manufacturing also has two bond issues
outstanding. The first bond issue has a face value of $70 million and a coupon rate of 7% and
sells for 108.3% of par. The second issue has a face value of $60 million and a coupon rate
of 7.5% and sells for 108.9% of par. The first issue matures in 8 years, the second in 27 years.
REQUIRED:

d) What are Filer’s capital structure weights on a book value basis?

e) What are Filer’s capital structure weights on a market value basis?
f) Which are more relevant, the book or market value weights? Why?

Floyd Industries stock has a beta of 1.3. The company just paid a dividend of $.95, and the
dividends are expected to grow at 4.5% per year. The expected return on the market is 11%,
and Treasury bills are yielding 4.3%. The most recent stock price for Floyd is $64.
REQUIRED:

a) Calculate the cost of equity using the DDM method.

b) Calculate the cost of equity using the SML method.
c) Why do you think your estimates in (a) and (b) are so different?
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