Question

ABC Inc is looking to launch an acquisition of a target for $3 billion. The target is expected to generate cash flows for five years. Table 1 below shows the expected cash flows of the target along with the acquisition cost. Table 2 shows the financial data required to generate a discount factor for the cash flows. Calculate the discount rate (WACC) for the acquisition. Evaluate the deal using NPV, IRR, and Payback. Consider the following: Table 1. Table 2. Cost of acquisition: $3.0 billion Debt/Equity 0.40 Cash flow, 1 $550 million Target cost of debt 12.00% Cash flow, 2 $700 million Tax rate 30% Cash flow, 3 $825 million Treasury rate 4.0% Cash flow, 4 $1.2 billion Beta with SPX 1.14 Cash flow, 5 $1.5 billion Return on SPX 10.0% Use the cash flows associated with Table 1 (there is no salvage value after year 5) and calculate the firm’s cost of capital using the information in Table 2. Find the NPV and IRR on the proposed acquisition.

Answer 1

Solution: D/E Ratio = 0.40 =40/100

Cost of capital = wd x rd x (1-t) + we x re

wd = Weight of debt = 40/140 = 0.29

we = Weight of equity = 100/140 = 0.71

rd = Cost of debt = 12%

t = 30%

re = Cost of equity

Cost of equity is calculated via Capital Asset Pricing Model (CAPM) = rf + Beta (rm - rf)

rf = Risk free rate (Treasury rate)

rm =Market Return (Return on SPX)

re = 4% + 1.14 x (10% - 4%) = 10.84%

Cost of capital = 0.29 x 12% (1 - 30%) + 0.71 x 10.84% = 10.13%

NPV = PV of future cash flows - Initial Investment

PV of future cash flows = CF1 (1+r%)¹ + CF2 (1+r%)²? + CF3 (1+r%)³? + CF4 (1+r%)⁴? + CF5 (1+r%)⁵?

= 550 (1+0.1013)¹ + 700 (1+0.1013)²? + 825 (1+0.1013)³? + 1200 (1+0.1013)⁴? + 1500 (1+0.1013)⁵?

= $3,435.85 Millions

NPV = $3,435.85 M - $3,000 M = $435.85 M

IRR is the rate at which NPV = 0 . It can be calculated easily with help of IRR function in excel and also on financial calculator. Calculating IRR manually is a tiresome process as it require hit and trial. IRR = 14.78%

Payback Period = It is the length of time required to recover the cost of an investment. As you can see in the image below after 3 years -$925 of Net cash flow is yet to be recovered and hence, it will be recovered proportionately out of 4th years' cash flow (925/1200 =0.77) Hence, payback period is 3 + 0.77 = 3.77 years.

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