Question

Company valuation/ M&A/Financial leverage

Pursuing Myron Bronco: Wouldn’t it be good?:

It was right at the beginning of 2019. Myron Bronco Incorporation (MB) was a medium-sized company listed in a share market. Largely owned by a traditional and financially conversative elite family, the company operated in a lower-risk and mildly-competitive industry. With thin trading of its shares in the stock exchange, the family has been considerably successful in controlling major decisions/directions made by the company. The family-owners of the company also take pride with the fact the business has managed to stay constantly debt-free (long-term debt) for more than a decade or so.

In the same share market, there was an active group of hedge funds that seek for companies that can be easily turned around to create additional value. Circling Vulture Fund (CVF) was one of them. Surely and slowly enough, CVF has recently set its eyes on MB.

At the beginning of 2019, Genghis Smith, the managing partner of CVF projected the future (debt-free) free cash flows of MB as follows:

Year (End of year)	FCF
2019	16.2 mil
2020	18.9 mil
2021	21.6 mil
2022	24.3 mil
2023	27.0 mil
2024	29.7 mil
2025	32.4 mil

After 2025, yearly FCFs are projected to be perpetual and stay at 32.4 million $.

The Beta of MB from regression estimation (based on the past three-year daily data) is 0.75. The relevant risk-free rate and the market risk premium were 5% and 2% respectively. The treasury department of MB estimates the cost of debt if the company is to borrow to be 5.5% per year.

As observed in the beginning of 2019, share price of MB was 150 while EPS was 30. The number of shares outstanding was 5 million shares. The P/E ratio of the slow-growth industry MB belongs to was only 3.

The corporate tax rate is 21%.

Answer the following questions:

1) Explain why Myron Bronco Incorporation (MB) has drawn the attention of an activeinvestor strategy such as CVF at the point in time of this case study (e.g. assume we are right at the beginning of 2019). In your answer, also take into account the surrounding economic factors.

2) What is the intrinsic value of MB in Genghis Smith’s perception?

3) Genghis Smith, with the backup VCF, plans to take over (acquire the majority stake of Myron Bronco) and then re-leverage MB by issuing a 15 year corporate debt at the fixed interest rate of 5.5% per year. The plan is for MB to borrow towards its own industry’s average debt financing appeared in the accounting book (book-based D/E ratio of the industry is 1.8). The book value of equity of MB is 450 mil$. How much value can be added to MB Incorporation based on this proposal?

4) What is MB’s WACC after recapitalisation (based on CVF’s proposal)?

5) Estimate the financial distress (bankruptcy) cost through put option valuation. Assume that the market value of the company’s assets before recapitalisation is $750 million. The variance of the company’s share price is estimated as 2.25% (reasonable proxy for the company’s assets volatility since there has been no debt usage in the firm). Assume a zero dividend yield. The natural number is ‘2.718’. Interpret the result. You are encouraged to use Excel for the calculations.

6) Ignore additional perspectives of the proposal on signalling effects, voting rights, difficulties to take over corporate control, and others. If the costs involving in the process of the takeover deal (e.g. transaction costs) are estimated as 1.5 mil $, what is the maximum price CVF should offer to buy MB Incorporation? Do you think Genghis Smith should/could pursue this proposal?

Answer 1

I question
CVF has shown intrest to gain from debt financing because optimum use of debt in compay will
maximise value of company as debt capital is cheaper than that of own capital.
II question
Beta	0.75
Rf	5%
Rm-Rf	2%
Ke	6.50%
Kd	5.50%
Tax rate	21%
Valuation of company (Debt free)
WACC	6.50%
yr	mil	PVF	DCF
2019	16.2	0.939	15
2020	18.9	0.882	17
2021	21.6	0.828	18
2022	24.3	0.777	19
2023	27	0.730	20
2024	29.7	0.685	20
2025	32.4	0.644	21
after 2025	498.46154	0.644	321
			450
Number of shares	5 million shares
Market price	150
EPS		30
P/E of industry	3
P/E of MB	5
PE of company > industry average means company stock is overvalued.
III question
D/E of industry	1.8
Rate	5.50%	15 year corporate debt
Book value of equity	450
Book value of firm	1260
Book value of debt	810
Tax rate	21%
Value that can be added = D(1-t)	640
IV question
Debt	810	0.643	4.35%	2.79%
Equity	450	0.357	6.50%	2.32%
	1260	1		5.11%
Notes: Here Kd = 5.5%(1-21%)