Question

Lee Enterprises and Jackson Distributors are considering a merger. Projections for the coming year for the companies operating independently are as follows:

Lee Enterprises:
EBIT = $200,000
Change in Working Capital = $20,000
Capital Spending = $30,000
Depreciation Expense = $20,000

Jackson Distributors:
EBIT = $450,000
Change in Working Capital = $45,000
Capital Spending = $75,000
Depreciation Expense = $50,000

Before the merger, the firms have the same cost of capital of 14% and the same expected perpetual growth rate of 4%. After the merger, the combined firms are expected to have a cost of capital of 13% and a perpetual growth rate of 5%. The tax rate for both firms is 40%.

What is the pre-merger value of the combined firms?

Select one:

A. $1,800,000

B. $2,900,000

C. $3,400,000

D. None of the above

Answer 1

Pre-Merger cash flow of the firms = EBIT* (1-Tax rate) + Depreciation – Working Capital – Capital Spending

Adding up the total operating profits, depreciation, working capital and capital spending of both firms Lee Enterprises and Jackson Distributors

Total Operating Profits* (1-tax rate) = ($200,000 + $450,000) *0.6 = $390,000

Total Depreciation = $20,000 + $50,000 = $70,000

Total Working Capital = $20,000 + $45,000 = $65,000

Total Capital Spending = $30,000 + $75000 = $105,000

Pre-Merger cash flow of the firms = $390,000 + $70,000 - $65,000 - $105,000 = $290,000

Now value of the Pre-Merger Combined Firms = $290,000* (1+ growth rate) / (cost of capital – growth rate)

Growth rate and Cost of Capital are same for both the enterprises, so

Pre-Merger Value of the Combined Firms = $290,000/ (0.14-0.04) = $29, 00,000 (since the cash flows are projected so growth is already adjusted)

Therefore, Pre-Merger Value of the Combined Firms is $29, 00,000

Correct Option is Option (b).