Question

Merger Valuation with Change in Capital Structure

VolWorld Communications Inc., a large telecommunications company, is evaluating the possible acquisition of Bulldog Cable Company (BCC), a regional cable company. VolWorld's analysts project the following post-merger data for BCC (in thousands of dollars, with a year end of December 31):

	2016	2017	2018	2019	2020	2021
Net sales		$450.0	$518.0	$  555.0	$  600.0	$  643.0
Selling and administrative expense		45.0	53.0	60.0	68.0	73.0
Interest		40.0	45.0	47.0	52.0	54.0
Total net operating capital	800.0	850.0	930.0	1,005.0	1,075.0	1,150.0
Tax rate after merger: 40%
Cost of goods sold as a percent of sales: 45%
BCC's pre-merger beta: 1.30
Risk-free rate: 5%
Market risk premium: 7%
Terminal growth rate of free cash flows: 6%

If the acquisition is made, it will occur on January 1, 2017. All cash flows shown in the income statements are assumed to occur at the end of the year. BCC currently has a capital structure of 40% debt, which costs 8.50%, but over the next 4 years VolWorld would increase that to 50%, and the target capital structure would be reached by the start of 2021. BCC, if independent, would pay taxes at 25%, but its income would be taxed at 40% if it were consolidated. BCC's current market-determined beta is 1.30. The cost of goods sold is expected to be 45% of sales.

What is the unlevered cost of equity for BCC? Do not round intermediate calculations. Round your answer to two decimal places.
%

What are the free cash flows and interest tax shields for the first 5 years? Do not round intermediate calculations. Enter your answers in thousands. For example, an answer of $1.2 thousand should be entered as 1.2, not 1,200. Round your answers to two decimal places.

	2017	2018	2019	2020	2021
The free cash flows	$	$	$	$	$
The interest tax shields	$	$	$	$	$

What is BCC's horizon value of interest tax shields and unlevered horizon value? Do not round intermediate calculations. Enter your answers in thousands. For example, an answer of $1.2 thousand should be entered as 1.2, not 1,200. Round your answers to two decimal places.

Horizon value of interest tax shields	$ thousand
Unlevered horizon value	$ thousand

What is the value of BCC's equity to VolWorld's shareholders if BCC has $300,000 in debt outstanding now? Do not round intermediate calculations. Enter your answer in thousands. For example, an answer of $1.2 thousand should be entered as 1.2, not 1,200. Round your answer to two decimal places.
$ thousand

Answer 1

Part A)

The unlevered cost of equity is calculated as follows

Unlevered Cost of Equity = Weight of Debt*Cost of Debt + Weight of Equity*Cost of Equity

Where Cost of Equity = Risk Free Rate + Beta*Market Risk Premium

______

Using the values provided in the question, we get,

Cost of Equity = 5% + 1.30*7% = 14.10%

Unlevered Cost of Equity = 40%*8.50% + 60%*14.10% = 11.86%

Part C)

The horizon value of tax-shields is calculated as follows:

Horizon Value of Tax Shields = Tax Shield for Year 5*(1+Growth Rate)/(Unlevered Cost of Equity - Growth Rate)

Using the values calculated above, we get,

Horizon Value of Tax Shields = 21.60*(1+6%)/(11.86% - 6%) = $390.71 thousand

_______

The unlevered horizon value is calculated as follows:

Unlevered Horizon Value = Free Cash Flow for Year 5*(1+Growth Rate)/(Unlevered Cost of Equity - Growth Rate)

Using the values calculated above, we get,

Unlevered Horizon Value = 39.07*(1+6%)/(11.86% - 6%) = $709.14 thousand