Question

1. Ocular Solutions recently (at the beginning of year 1) forecasted first year sales of $9.4 million, operating costs other than depreciation of $5.6 million, and depreciation of $0.6 million. The company has no amortization charges, it has $4.2 million of outstanding bonds that carry a 6.5% interest rate, and its income tax rate is 28%. In order to sustain its operations and thus generate sales and cash flows in the future, the firm is required to make $1.3 million of capital expenditures on new fixed assets and to invest $0.3 million in net working capital.

a) Calculate the FCF of the firm in the first year. [5 Marks]

b) Assuming that the firm’s FCF will grow at a rate of 3% forever after Year 1, and also that its WACC is 20.0%, estimate the market value of the firm and its debt ratio (Debt/Firm Value) at the beginning of year 1. [5 Marks]

c) If the company keeps the debt level unchanged in the future, estimate its debt ratio at the beginning of year 2, and beginning of year 3. [5 Marks] d) Discuss the potential problem when using the WACC method to answer parts b) and c) above.

2. American Hardware (AH), a national hardware chain, is considering purchasing a smaller chain, Eastern Hardware (EH). American Hardware's analysts project that the merger will result in incremental free cash flows and interest tax savings. In the first two years, the incremental FCF is $3 million each year and the value increases to $3.5 million each year after the period. The tax savings are $0.5 million annually starting from the first year. They have determined that the appropriate discount rate for valuing EH (for both FCF and interest tax savings) is 17 percent. EH has 7 million shares outstanding and AH has 56 million shares outstanding. EH's current share price is $14.25 and AH’s current share price is $28.25. a). What is the maximum price per share that AH should offer (under the condition that all of the proposed synergy value is distributed to the EH shareholders)? [6 marks] b). If the proposed synergy value is equally distributed between AH shareholders and EH shareholders (50% to all AH shareholders and 50% to all EH shareholders), what is the price per share that AH should offer? [7 marks] c). If AH has successfully purchased all of EH shares at the price of $18, what should AH share price be after the purchasing (assuming investors know the information precisely as described above)?

a). What is the maximum price per share that AH should offer (under the condition that all of the proposed synergy value is distributed to the EH shareholders)? [6 marks] b). If the proposed synergy value is equally distributed between AH shareholders and EH shareholders (50% to all AH shareholders and 50% to all EH shareholders), what is the price per share that AH should offer? [7 marks] c). If AH has successfully purchased all of EH shares at the price of $18, what should AH share price be after the purchasing (assuming investors know the information precisely as described above)?

b). If the proposed synergy value is equally distributed between AH shareholders and EH shareholders (50% to all AH shareholders and 50% to all EH shareholders), what is the price per share that AH should offer?

c). If AH has successfully purchased all of EH shares at the price of $18, what should AH share price be after the purchasing (assuming investors know the information precisely as described above)?

Answer 1

(a) At the end of year 1:

Sales = $ 9.4 million

LESS: Operating Expenses = $ 5.6 million

EBITDA = $ 3.8 million

LESS: Depreciation = $ 0.6 million

EBIT = $ 3.2 million

LESS: Tax at 28 % = 0.28 x 3.2 = $ 0.896 million

NOPAT = $ 2.304 million

ADD: Depreciation = $ 0.6 million

LESS: Capital Expenditure = $ 1.3 million

LESS: Changes in Net Working Capital (NWC) = $ 0.3 million

FCF = 2.304 + 0.6 - 1.3 - 0.3 = $ 1.304 million

(b) Growth Rate = g = 3 % and WACC = 20 %

FCF1 = $ 1.304 million

Market Value at end of Year 0 or beginning of Year 1 = 1.304 / (0.2 - 0.03) = $ 7.67 million

Debt Value = $ 4.2 million

Debt / Market Value = 4.2 / 7.67 = 0.548

(c) FCF2 = 1.304 x 1.03 = $ 1.343 million

FCF3 = 1.343 x 1.03 = $ 1.38329 million

Market Value at end of Year 1 or beginning of Year 2 = 1.343 / (0.2 - 0.03) = $ 7.9 million

Market Value at end of Year 2 or beginning of Year 3 = 1.38329 / (0.2 - 0.03) = $ 8.137 million

(d) One issue with using WACC in the discount factor is the underlying assumption that the firm's debt to equity ratio remains constant throughout which is usually not the case as a firm's debt and equity levels keep varying which in turn lead to changes in the firm's WACC and thereby its discounting factor.

NOTE: Please raise separate queries for solutions to the remaining sub-parts.