Question

Eades Logistics Corp., which is considering the acquisition of Exteter Enterprise Inc., estimates that acquiring Exteter will result in an incremental value for the firm. The analysts involved in the deal have collected the following information from the projected financial statements of the target company:

Data Collected (in millions of dollars)
	Year 1	Year 2	Year 3
EBIT	$9.0	$10.8	$13.5
Interest expense	3.0	3.3	3.6
Debt	31.9	37.7	40.6
Total net operating capital	109.2	111.3	113.4

Exteter Enterprise Inc. is a publicly traded company, and its market-determined pre-merger beta is 1.60. You also have the following information about the company and the projected statements:

•	Exteter currently has a $28.00 million market value of equity and $18.20 million in debt.
•	The risk-free rate is 5%, there is a 7.10% market risk premium, and the Capital Asset Pricing Model produces a pre-merger required rate of return on equity rsLsL of 16.36%.
•	Exteter’s cost of debt is 7.00% at a tax rate of 35%.
•	The projections assume that the company will have a post-horizon growth rate of 5.00%.
•	Current total net operating capital is $106.0, and the sum of existing debt and debt required to maintain a constant capital structure at the time of acquisition is $29 million.
•	The firm does not have any nonoperating assets such as marketable securities.

Given this information, use the adjusted present value (APV) approach to calculate the following values involved in merger analysis. (Note: Only round intermediate calculations when entering them as a final answer.)

	Value
Unlevered cost of equity
Horizon value of unlevered cash flows
Horizon value of tax shield
Unlevered value of operations
Value of tax shield
Value of operations

Thus, the total value of Exteter’s equity is     .

Suppose Eades Logistics Corp. plans to use more debt in the first few years of the acquisition of Exteter Enterprise Inc. Assuming that using more debt will not lead to an increase in bankruptcy costs for Eades Logistics Corp., the interest tax shields and the value of the tax shield in the analysis, will     , leading to a      value of operations of the acquired firm.

The APV approach is considered useful for valuing acquisition targets, because the method involves finding the values of the unlevered firm and the interest tax shield separately and then summing those values. Why is it difficult to value certain types of acquisitions using the corporate valuation model?

Because the acquisition is usually financed with new debt that will be repaid rapidly, the proportion of debt in the capital structure changes after the acquisition.

Because the acquisition is usually financed with equity and no new debt, the proportion of debt in the capital structure remains constant after the acquisition.

Answer 1

Calculation of cost of unlevered equity:
TV = Equity value + Debt value	Total value	46.20
Equity value/TV	Weight of equity (ws)	0.61
Debt value/TV	Weight of debt (wd)	0.39
Using CAPM	Cost of levered equity (rsL)	16.36%
	Cost of debt (rd)	7.00%
(ws*rsL) + (wd*rd) 9.9796	Cost of unlevered equity (rsU)	12.71%

Value of unlevered operations:
Formula	Year (n)	0	1	2	3	Perpetuity
	Growth rate g					5%
	EBIT		9.00	10.80	13.50
EBIT*Tax	Tax @ 35%		3.15	3.78	4.725
EBIT - Tax	After-tax EBIT (AT EBIT)		5.85	7.02	8.775
	Total net operating capital (NOC)	106.00	109.20	111.30	113.40
NOCn - NOCn-1	Less: Change in net operating capital		3.20	2.10	2.10
AT EBIT - Change in net op. capital	Free Cash Flow (FCF)		2.65	4.92	6.675	7.01
FCF4/(rsU -g)	Horizon value (HV)					90.92
	Total FCF (TFCF)		2.65	4.92	6.675	90.92
1/(1+rsU)^n	Discount factor @ rsU		0.887	0.787	0.698	0.698
(Total FCF*Discount factor)	PV of FCF		2.35	3.87	4.66	63.46
Sum of all PVs	Total PV	74.34

Value of tax shield:
Formula	Year (n)	0	1	2	3	Perpetuity
	Growth rate (g)					5%
(I5 = I4*(1+g)	Interest		3.00	3.30	3.60	3.78
	Tax @ 35%		35%	35%	35%	35%
(Interest*Tax)	Tax shield (TS)		1.05	1.155	1.26	1.323
TS5/(rsU-g)	Horizon value					17.16
	Total TS		1.05	1.155	1.26	17.16
1/(1+rsU)^n	Discount factor @ rsU		0.887	0.787	0.698	0.698
(Total TS*Discount factor)	PV of TS		0.93	0.91	0.88	11.98
Sum of all PVs	Total PV	14.7

		Answers
rsU	Unlevered cost of equity	12.71%
HV FCF	Horizon value of unlevered cash flows	90.92
HV TS	Horizon value of tax shield	17.16
PVunlevered	Unlevered value of operations	74.34
PVtaxshield	Value of tax shield	14.7
V = PVunlevered + PVtaxshield	Value of operations	89.04
D	Less: debt	18.2
V-D	Equity value	70.84

(rounding differences will be there)

Assuming that using more debt will not lead to an increase in bankruptcy costs, the interest tax shields and value of the tax shield will increase, leading to a higher value of operations of the acquired firm.

Optio 1 is correct - Because the acquisition is usually financed with new debt that will be repaid rapidly, the proportion of debt in the capital structure changes after the acquisition.