Question

You, CFO of Wharton Inc., have been asked to assess a potential buyout of competitor, Rotman Inc. The Rotman Inc. has the after-tax operating income of $12 million. It is expected to generate this operating income forever (with no growth). The cost of equity for this firm is 20% and it has no debt outstanding. a) Assume that as an acquiring firm, you are in a much safer business and have a cost of equity of 10%. What is the value of the target firm to you? Justify your answer. b) Assume as an acquirer that you have access to cheap debt (at 4%) and that you plan to fund half the acquisition with debt. How much would you be willing to pay for the target firm? Justify your answer.

Answer 1

Value of a firm (As per Cash Flow Discounting Model):

(a) Firm's cost of equity means anybody investing as shareholder in this risky business will expect a return of 20% from the business. Hence, it is valued in the market at 20% cost of equity-

Value of the firm will be = $ 12 Million / Cost of Equity (20%)

= $60 Million

(b) For $60 Million, firm will be getting Debt @4% (Tax Information not given. We are assuming it after tax cost),

Annual Cost of Debt - $30 Mn * 4% = $1.2Mn

Annual Cash Flows for us - $12Mn - $1.2Mn = $10.8Mn

Cost of Equity for our firm is 10%. Hence, our shareholders expect return of 10% from our investments/business. Hence, we will discount it at 10% i.e.

= Cash Flows ($10.8Mn) / Cost of Equity (10%)

= 108 Mn

The answer coming is illogical. Because, risk factors are not discounted. Just taking two different cost of equities on the basis of risk on two different businesses will only not serve the purpose. Discounting of Risk will also reduce the valuation in such scenario.