Question

Merger Analysis TransWorld Communications Inc., a large telecommunications company, is evaluating the possible acquisition of Georgia Cable Company (GCC), a regional cable company. TransWorld's analysts project the following post-merger data for GCC (in thousand of dollars): 2015 2016 2017 2018 Net Sales $482 $540 $584 $631 Selling and administrative expense 42 52 61 69 Interest 18 21 24 27 Tax rate after merger 30% Cost of goods sold as a percent of sales 80% Beta after merger 1.663 Risk-free rate 6% Market risk premium 5% Continuing growth rate of cash flow available to TransWorld 7% If the acquisition is made, it will occur on January 1, 2015. All cash flows shown in the income statements are assumed to occur at the end of the year. GCC currently has a capital structure of 40% debt, but Trans World would increase that to 50% if the acquisition were made. GCC, if independent, would pay taxes at 20%; but its income would be taxed at 30% if it were consolidated. GCC's current market-determined beta is 1.50, and its investment bankers think that its beta will rise to 1.663 if the debt ratio were increased to 50%. The cost of goods sold is expected to be 80% of sales, but could vary somewhat. Depreciation-generated funds would be used to replace worn-out equipment, so they would not be available to TransWorld's shareholders. The risk-free rate is 6%, and the market risk premium is 5%. Do not round intermediate calculations. What is the appropriate discount rate for valuing the acquisition? % (to 2 decimals) What is the continuing value? $ thousand (to 1 decimal) What is the value of GCC to TransWorld? $ thousand (to 1 decimal)

Answer 1

Discount Rate for acquisition will be derived from CAPM. Hence, discount rate = Risk Free Rate + Market Risk Premium X Beta = 6% + 1.663 X 5% = 14.32%

Continuing Value of GCC would be based on current situation of business (without bringing in the effects due to TransWorld). The breakdown of free cash flow will be as follows:

	2015	2016	2017	2018
Net Sales	482	540	584	631
COGS (80% of Sales)	386	432	467	505
Selling and administrative expense	42	52	61	69
EBITDA	54	56	56	57
EBITDA X (1-Tax Rate)	44	45	45	46

Considering depreciation is given as equal to capital expenditure. Hence, EBITDA X (1-Tax Rate) will be the free cash flow generated. Discount Rate in the continuing case is 13.5% (considering a beta of 1.5).

Using the standard FCF to EV calculation, we can calculate the continuing value as shown below:

	Year 1	Year 2	Year 3	Year 4
Free Cash Flow	43.5	44.8	44.6	45.8
Terminal Value = FCF in Year 4 * (1+ Growth Rate)/(Discount Rate - Growth Rate)				753.3
Discounted Free Cash Flow	38.3	34.8	30.5	481.5
Enterprise Value	585.1

Hence, continuing value (in thousand of $) = $ 585.1

Now, to calculate value to TransWorld, we will change the applied discount rate & tax rate.

For transworld, free cash flow calculation will be:

	2015	2016	2017	2018
Net Sales	482	540	584	631
COGS (80% of Sales)	386	432	467	505
Selling and administrative expense	42	52	61	69
EBITDA	54	56	56	57
EBITDA X (1-Tax Rate)	38	39	39	40

In this case, the EV calculation will be as follows:

	Year 1	Year 2	Year 3	Year 4
Free Cash Flow	38.1	39.2	39.1	40.0
Terminal Value = FCF in Year 4 * (1+ Growth Rate)/(Discount Rate - Growth Rate)				585.7
Discounted Free Cash Flow	33.3	30.0	26.1	366.4
Enterprise Value	455.9

Hence, the value of GCC to TransWorld will be $ 455.9 (in thousands of $).