Question

Problem 22-05
Merger Analysis

Marston Marble Corporation is considering a merger with the Conroy Concrete Company. Conroy is a publicly traded company, and its beta is 1.30. Conroy has been barely profitable, so it has paid an average of only 25% in taxes during the last several years. In addition, it uses little debt; its target ratio is just 30%, with the cost of debt 8%.

If the acquisition were made, Marston would operate Conroy as a separate, wholly owned subsidiary. Marston would pay taxes on a consolidated basis, and the tax rate would therefore increase to 35%. Marston also would increase the debt capitalization in the Conroy subsidiary to wd = 40%, for a total of $18.15 million in debt by the end of Year 4, and pay 11.0% on the debt. Marston's acquisition department estimates that Conroy, if acquired, would generate the following free cash flows and interest expenses (in millions of dollars) in Years 1-5:

Year	Free Cash Flows	Interest Expense
1	$1.30	$1.2
2	1.50	1.7
3	1.75	2.8
4	2.00	2.1
5	2.12	?

In Year 5, Conroy's interest expense would be based on its beginning-of-year (that is, the end-of-Year-4) debt, and in subsequent years both interest expense and free cash flows are projected to grow at a rate of 8%.

These cash flows include all acquisition effects. Marston's cost of equity is 8.2%, its beta is 1.2, and its cost of debt is 8.0%. The risk-free rate is 4%, and the market risk premium is 3.5%. Use the compressed APV model to answer the following questions.

What is the value of Conroy's unlevered operations? Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places.
$ million

What is the value of Conroy's tax shields under the proposed merger and financing arrangements? Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. Do not round intermediate calculations.
$ million

What is the dollar value of Conroy's operations? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places.
$ million

If Conroy has $8 million in debt outstanding, how much would Marston be willing to pay for Conroy? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. Do not round intermediate calculations.
$ million

Answer 1

Part A:

Cost of Equity = Risk Free Rate + Beta*(Market Risk Premium) = = 4% + 1.2(3.5%) = 8.2%

Unlevered Cost of Equity = 30%*8% + 70%*8.2% = 8.14%

Unlevered Value of Horizon = Free Cash Flow in Year 5*(1+Growth Rate)/(Unlevered Cost of Equity - Growth Rate) = 2.12*(1+.08)/(.0814-.06) = 106.99 million

Unlevered Value of Operations (Vop Unlevered) = 1.3/(1+.0.0814)^1 + 1.5/(1+.0.0814)^2 + 1.75/(1+.0.0814)^3 + 2/(1+0.0814)^4 + (2.12+106.99)/(1+0.0814)^5 = $78.723 million

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Interest in Year 5 = Value of Debt in Year 4*(11%) = 18.15 *11% = 1.9965Million

Tax Shield in Year 5 = Interest in Year 5*(Tax Rate) = $1.9965 *(.35%) = .6988 Millionn (post merger tax rate is to be used)

For other years, the tax shield will be calculated by multiplying the interest amount with the tax rate.

Tax Shield in Year 1 = 1.2*.35 = .42

Tax Shield in Year 2 = 1.7*.35 = .595

Tax Shield in Year 3 = 2.8*.35 = .98

Tax Shield in Year 4 = 2.1*.35 = .735

Horizon Value Tax Shield in Year 5 = Tax Shield in Year 6/(Unlevered Cost of Equity - Growth Rate) = .6988*(1.06)/(.0.0814 - .06) = 34.63 million

Value of Tax Shields (Vtax shields) = .42/(1+.0814)^1 + .595/(1+.0814)^2 + .980/(1+.0814)^3 + .735/(1+.0814)^4 + (.6988+34.63)/(1+.0814)^5 = $64.55 million

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Part B:

New Levered Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity - Cost of Debt)*(D/S) = 0.0814% + (0.814%-11%)*(.40/.60) = 6.71%

WACC = .40*11%*(1-.35) + .20*(6.71%) = 4.21%

Horizon Value = Free Cash Flow in Year 4*(1+Growth Rate)/(WACC