Question

Simon Corporation is considering the acquisition of Ingram Company. Ingram has a capital structure consisting of $7.5 million (market value) of 11% bonds and $15 million (market value) of common stock. Ingram's pre-merger beta is 1.36. Simon's beta is 1.02, and both it and Ingram face a 40% tax rate. Simon's capital structure is 40% debt and 60% equity. The free cash flows from Ingram are estimated to be $4.5 million for each of the next 4 years and a horizon value of $15 million in Year 4. Tax savings are estimated to be $1.5 million for each of the next 4 years and a horizon value of $7.5 million in Year 4. New debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%. What is the value of Ingram’s equity to Simon? (Round your answer to the closest thousand dollars.)

A. $25.66 million

B. $27.111 million

C. $17.111 million

D. $17.111 million

Answer 1

First we need to find out the discount rate for value of operations

The correct discount rate should be the unlevered cost of equity.

The levered cost of equity is 6% + 1.36(4%) = 11.44%, (This is CAPM Model, Re = Rf + B (Rm-Rf) )

Debt percentage is 7.5/(7.5+10) = 0.334  

The rate on the debt is 11%

The unlevered cost of equity is WdRd+ WeRe= 0.334(11%) + 0.667(11.44%) = 11.29%

Value of equity: -

Using discount rate as 11.29%

From the question "The free cash flows from Ingram are estimated to be $4.5 million for each of the next 4 years and a horizon value of $15 million in Year 4. Tax savings are estimated to be $1.5 million for each of the next 4 years and a horizon value of $7.5 million in Year 4."

so to calculate the PV - each years cash flow = 4.5+1.5 = 6M

horizon value @ 4th year = 15 +7.5 = 22,500,000

= 6M / (1+11.29%) + 6M / (1+11.29%)^2 + 6M / (1+11.29%)^3 + 6M / (1+11.29%)^4 + 22.5M / (1+11.29%)^4

= 33167562.45

subtract market value of Ingram's debt to get value of Ingram’s equity to Simon:

=  33167562.45 -7.5M = 25.66756245

(option A)

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