Question

On December 8, 2015, ABC store announced they were buying 123 Co for $13.9 billion. The deal was for $92 per share, a 78% premium to 123 CO.December 4 closing price of $51.70 per share.Summary financial data for 123 Co before the deal is shown below (equity shown is Book Value). the company’s equity beta before the buyout proposal is 1.0, the same level as the overall market.ABC store announced that they would operate 123 Co similarly to their other brands, with a 40% debt:capital ratio (D/(D+E). Because of their size and diversification, ABC store expected to reduce 123 Co borrowing cost by 1%, and to lower the tax rate to 30%.Question Calculate 123 Co weighted average cost of capital before the acquisition (using book value weights) and after the acquisition using the new proposed capital structure weights of 40% debt:capital. SHOW ALL STEPS IN YOUR CALCULATIONS In a couple sentences, explain your results.

sales $4585 mill ; net income $495 mill; long term interest expense 33.7 mill; long term debt 410 mill; equity $3,550 mill; tax rate 35%; dividend yeild 2.10%; stock price 52 week high/low = $139.70/$45.30; Risk free rate Rf 2.0%; Rm-Rf spread 6%

Answer 1

Pre-Acquisition Weighted Average Cost of Capital:

Long Term Debt = $ 410 million, Equity = $ 3550 million, Total Capital = 410 + 3550 = $ 3960 million

Equity Proportion = (3550 / 3960) = 0.8965 and Debt Proportion = (410/3960) = 0.1035

Tax Rate = 35%, Risk-Free Rate = 2%, Rm-Rf = 6% and Equity Beta = 1

Cost of Equity = ke = 2 + 1 x 6 = 8 %

Long-Term Interest Expense = $ 33.7 million

Interest Rate = Interest Expense / Debt = 33.7 / 410 = 0.0822 or 8.22 %

Weighted Average Cost of Capital (WACC) = 8.22 x (1-0.35) x 0.1035 + 8 x 0.8965 = 7.725 %

Post-Acquisition Weighted Average Cost of Capital:

Target Capital Structure: 40% Debt and 60 % Equity, Tax Rate = 30 %

Original Equity Beta = 1

Original Asset Beta = 1 / [1+(0.1035/0.8965) x (1-0.35)] = 0.93

New Equity Beta = 0.93 x [1+(1-0.35) x (0.4/0.6)] = 1.33

New Cost of Equity = 2 + 1,33 x 6 = 9.99% ~ 10%

New Cost of Debt = 8.22 - 1 = 7.22%

Therefore, New WACC = 7.22 x (1-0.3) x 0.4 + 9.99 x 0.6 = 8.02 %