Question

1. Dave’s Pizza – Fulton Pizza Merger

Dave’s pizza is considering a merger with Fulton Pizza. The offer under discussion is a cash offer of $352 million for Fulton Pizza. Both companies have niche markets in the pizza industry, and the companies believe a merger will result in significant synergies due to economies of scale in manufacturing and marketing, as well as significant savings in general and administrative expenses.

Matt Robinson, the financial officer for Dave’s, has been instrumental in the merger negotiations. Matt has prepared the following pro forma financial statements for Fulton assuming the merger takes place. The financial statements include all synergistic benefits from the merger:

	2015	2016	2017	2018	2019
Sales	$512,000,000	$576,000,000	$640,000,000	$720,000,000	$800,000,000
Production costs	359,200,000	403,200,000	448,000,000	505,600,000	564,000,000
Depreciation	48,000,000	51,200,000	52,800,000	53,120,000	53,600,000
Other expenses	51,200,000	57,600,000	64,000,000	72,320,000	77,600,000
EBIT	$ 53,600,000	$ 64,000,000	$ 75,200,000	$ 88,960,000	$104,800,000
Interest	12,160,000	14,080,000	15,360,000	16,000,000	17,280,000
Taxable Income	$ 41,440,000	$ 49,920,000	$ 59,840,000	$ 72,960,000	$ 87,520,000
Taxes @40%	16,576,000	19,968,000	23,936,000	29,184,000	35,008,000
Net Income	$ 24,864,000	$ 29,952,000	$ 35,904,000	$ 43,776,000	$ 52,512,000

Matt knows that Fulton will require investments each year for maintenance of plant. The table below has required investments and sources of financing:

	2015	2016	2017	2018	2019
Investments
Net working capital	$ 12,800,000	$ 16,000,000	$16,000,000	$19,200,000	$19,200,000
Fixed assets	9,600,000	16,000,000	11,520,000	76,800,000	4,480,000
Total	22,400,000	$ 32,000,000	$ 27,520,000	$ 96,000,000	$ 23,680,000
Sources of financing
New debt	$ 22,400,000	$ 10,240,000	$ 10,240,000	$    9,600,000	$    7,680,000
Profit retention	0	21,760,000	17,280,000	17,280,000	16,000,000
Total	22,400,000	32,000,000	27,520,000	26,880,000	23,680,000

The management of Dave’s feels that that capital structure at Fulton is not optimal. If the merger takes place, Fulton will immediately increase its leverage with a $71 million debt issue, which would be followed by a $96 million dividend payment to Dave’s. This will increase Fulton’s debt-to-equity ratio from 0.50 to 1.00. Dave’s will also be able to use a $16 million tax loss carryforward in 2016 and 2017 from Fulton’s previous operations. The total value of Fulton is expected to be $576 million in five years, and the company will have $192 million in debt at that time.

Stock in Dave’s currently sells for $94 per share, and the company has 11.6 million shares of stock outstanding. Fulton has 5.2 million shares of stock outstanding. Both companies can borrow at 8%. The risk-free rate is 6%, and the expected return on the market is 13%. Matt believes the current cost of capital for Dave’s is 11%. The beta for Fulton at its current capital structure is 1.30.

Matt has asked you to analyze the financial aspects of the potential merger. Specifically, he has asked you to answer the following questions:

1. Suppose Fulton’s shareholders will agree to a merger price of $68.75 per share. Should    Dave’s proceed with the merger?
2. What is the highest price per share that Dave’s should be willing to pay for Fulton?
3. Suppose Dave’s is unwilling to pay cash for the merger but will consider a stock exchange. What exchange ratio would make the merger terms equivalent to the original merger price of $68.75 per share?
4. What is the highest exchange ratio Dave’s would be willing to pay and still undertake the merger?                             

Answer 1