Question

Merger Analysis

TransWorld Communications Inc., a large telecommunications company, is evaluating the possible acquisition of Georgia Cable Company (GCC), a regional cable company. TransWorld's analysts project the following post-merger data for GCC (in thousand of dollars):

			2015		2016		2017		2018
Net Sales			$423		$474		$512		$569
Selling and administrative expense			40		48		57		64
Interest			18		21		24		27
Tax rate after merger	35%
Cost of goods sold as a percent of sales	80%
Beta after merger	1.614
Risk-free rate	8%
Market risk premium	4%
Continuing growth rate of cash flow available to TransWorld	9%

If the acquisition is made, it will occur on January 1, 2015. All cash flows shown in the income statements are assumed to occur at the end of the year. GCC currently has a capital structure of 40% debt, but Trans World would increase that to 50% if the acquisition were made. GCC, if independent, would pay taxes at 20%; but its income would be taxed at 35% if it were consolidated. GCC's current market-determined beta is 1.50, and its investment bankers think that its beta will rise to 1.614 if the debt ratio were increased to 50%. The cost of goods sold is expected to be 80% of sales, but could vary somewhat. Depreciation-generated funds would be used to replace worn-out equipment, so they would not be available to TransWorld's shareholders. The risk-free rate is 8%, and the market risk premium is 4%. Do not round intermediate calculations.

1. What is the appropriate discount rate for valuing the acquisition?
   % (to 2 decimals)

2. What is the continuing value?
   $ thousand (to 1 decimal)

3. What is the value of GCC to TransWorld?
   $ thousand (to 1 decimal)

Answer 1

a. Appropriate discount rate for valuing the acquisition is the WACC

here , as per the given details the cost of equity & before-tax cost of debt seem to be the same

which can be found out as per CAPM,

ie. Ke=RFR+(Beta*Risk premium)

ie. 8%+(1.614*4%)

14.46%

But the after-tax cost of debt=

14.46%*(1-35%)=

9.40%

So, the WACC, to discount the cashflows=

(Wt.e*ke)+(Wt.d*kd)

ie. (50%*14.46%)+(50%*9.40%)=

11.93%

	1	2	3	4
Year	2015	2016	2017	2018
Net sales	423	474	512	569
Less: COGS(Net sales*80%)	338.4	379.2	409.6	455.2
Gross profit	84.6	94.8	102.4	113.8
Less:S&A exp.	40	48	57	64
EBIT	44.6	46.8	45.4	49.8
Less: Tax at 35%	15.61	16.38	15.89	17.43
EAT	28.99	30.42	29.51	32.37
Add: Int.tax shields(int.*Tax rate)	6.3	7.35	8.4	9.45
FCF----1	35.29	37.77	37.91	41.82
b.Continuing value
(FCF4*(1+g))/(WACC-g)
(41.82*1.09)/(11.93%-9%)				1555.76	(Answer: $ 1555.8 ('000 s)
Total FCF	35.29	37.77	37.91	1597.581
PV F at 11.93%	0.89342	0.79819	0.71312	0.63711
PV at 11.93%	31.5286	30.1477	27.0342	1017.8339
NPV=	1106.5444
Answer:
c. Value of GCC to TransWorld
$1,106.50
('000s)