Question

Company XYZ is analyzing the possible acquisition of a privately-held oil company called O&G Inc. The financial information for O&G is shown below:

Revenues in 2018	$30 million
COGS as % of revenues	64%
Tax rate on income	35%
Depreciation as % of revenues	2.25%
CAPEX as % of revenues	3%
Working capital as % of revenues	2%

Company XYZ estimates that it can increase O&G’s free cash flows by reducing operating costs and capital expenditures. They estimate the following savings:

	2019-2021	After 2021
COGS as % of revenues	58%	54%
CAPEX as % of revenues	1%	0.50%

It is expected that the revenues of O&G will grow at a rate of 2.5% over the period 2019-2021 and then at a constant rate of 2% after the year 2021. O&G has no debt.

Since O&G is privately-held, its equity beta is not available. However, analysts at Company XYZ believe that ConocoPhillips (COP) and Chevron (CVX) can be used as comparable firms. Below is the the financial information for these two firms:

	Beta	Debt                        (Billions of $)	Book Value of Equity (Billions of $)	Market Value of Equity (Billions of $)
					ConocoPhillips	0.98	14.97	31.93	79.96
Chevron	0.91	36.11	153.57	227.65

Assume that the market risk premium is 6.5%, the risk free-rate is 5%, the cost of debt is 5%, and that the CAPM holds. Further, assume that you are doing the valuation at the beginning of 2019.

Company XYZ has a market value of equity of $850 million and 40 million shares outstanding.

a)If Company XYZ wants to capture 30% of the synergies, what should be the premium that it should pay for O&G?

Answer 1

a) Let's calculate unlevered beta of Firm O&G

Weighted book equity beta of comparable firms( considereing it will give more exact picture as O&G doesn't have debt)

Beta ( Levered) =(0.98X3+0.91*15)/(3+15)=0.922

Calculating average D/E=(17.97*(14.97/3)+51.11*36.11/15)/(17.97+51.11)(pictureis not clear assuming book equity=3 & 15)

D/E=3.079(it's coming high( I think the value is not correct, need more info abou equity of both comparable companies)

But i'll let you know the process:
Take this beta for calulating cost of equity and that would be your discounting factor:

Kce=5%+3.079*6.5%

An below attached image will clear the further calculations;

Remember NPV=EV=Market value-debt+cash