Question

11. Eastern Steel Manufacturing is considering acquiring Chicago Iron Works. Eastern Steel   

expects Chicago Iron Works’ free cash flow in the first year following the closing date for the  

acquisition will be $125 million and that it will grow thereafter at the rate of 10% per year for

the next 5 years. Eastern Steel’s WACC for the acquisition is 12%, and its investment banker

estimates that the perpetuity growth rate for calculating the terminal value is 2% per year.

1. Specify Chicago Iron Works’ free cash flow stream for years 1 through 6.
2. Estimate the terminal value for the acquisition.
3. Calculate the value of Chicago Iron Works.
4. Eastern Steel believes it can acquire Chicago Iron Works for $1.6 billion.  Should Eastern Steel proceed with the acquisition? Justify your answer.

Answer 1

(All values in million)

a) Free cash Flow to Firm(FCFF₁)= $125

FCFF₂=FCFF₁(1+g₁) [where, g₁=growth rate for 1^st phase=10%]

Year	FCFF($)
1	FCFF1=125(1+0.10)=137.5
2	FCFF2=137.5(1+0.10)=151.25
3	FCFF3=151.25(1+0.10)=166.38
4	FCFF4=166.38(1+0.10)=183.01
5	FCFF5=183.01(1+0.10)=201.31
6	FCFF6=201.31(1+0.10)=221.45

b) Terminal Value(V₆):

V₆= FCFF₇/(K₀-g₂) [where g₂=perpetuity growth rate=2% =FCFF₆(1+g₂)/(0.12-0.02) K₀=Cost of Capital=WACC=12%] =221.45(1+0.02)/0.10 =$ 2258.79

c) Value of Chicago Iron works(V):

   [Where, n=number of years] =

=$1597.69 million

d) Eastern Steel believes it can aquire Chicago Iron works at $1.6 billion.

Here we found the value of the firm as $1597.69million or 1.59 billion which is almost near to 1.6 billion. Therefore Eastern Steel should proceed with its acquisition.