Question

Tango Company is planning to acquire Delta Company. The additional pre-tax income from the acquisition will be $300,000 in the first year, but it will increase by 2% in future years. Because of diversification, the beta of Tango will decrease from 1.2 to 0.8. Currently the return on the market is 9% and the riskless rate is 4%. What is the maximum price that Tango should pay for Delta? The tax rate of Tango is 35%.

Answer 1

Solution:-

Expected return on Assets = Risk free return + (Expected market return - Risk free return) * Beta

= 4% + (9%-4%) * 0.8

= 4% + 5% * 0.8

= 4% + 4%

= 8%

Maximum price Tango to pay to Delta = Pre tax income * (1-tax rate) / (Expected return on assets - growth)

= $300,000 * (1-35%) / (8% - 2%)

= $300,000 * 65% / 6%

= $3,250,000

Therefore the maximum price that Tango to pay Delta is $3,250,000