Question

RTE Telecom Inc., which is considering the acquisition of Galaxy Sun Corp., estimates that acquiring Galaxy Sun will result in an incremental value for the firm. The analysts involved in the deal have collected the following information from the projected financial statements of the target company:

Data Collected (in millions of dollars)
	Year 1	Year 2	Year 3
EBIT	$16.0	$19.2	$24.0
Interest expense	5.0	5.5	6.0
Debt	31.9	37.7	40.6
Total net operating capital	121.5	123.9	126.3

Galaxy Sun Corp. is a publicly traded company, and its market-determined pre-merger beta is 1.40. You also have the following information about the company and the projected statements:

•	Galaxy Sun currently has a $28.00 million market value of equity and $18.20 million in debt.
•	The risk-free rate is 3%, there is a 5.10% market risk premium, and the Capital Asset Pricing Model produces a pre-merger required rate of return on equity rsL of 10.14%.
•	Galaxy Sun’s cost of debt is 5.00% at a tax rate of 30%.
•	The projections assume that the company will have a post-horizon growth rate of 4.00%.
•	Current total net operating capital is $118.0, and the sum of existing debt and debt required to maintain a constant capital structure at the time of acquisition is $29 million.
•	The firm does not have any nonoperating assets such as marketable securities.

Given this information, use the adjusted present value (APV) approach to calculate the following values involved in merger analysis. (Note: Only round intermediate calculations when entering them as a final answer.)

	Value
Unlevered cost of equity
Horizon value of unlevered cash flows
Horizon value of tax shield
Unlevered value of operations
Value of tax shield
Value of operations	Thus, the total value of Galaxy Sun’s equity is     . Suppose RTE Telecom Inc. plans to use more debt in the first few years of the acquisition of Galaxy Sun Corp. Assuming that using more debt will not lead to an increase in bankruptcy costs for RTE Telecom Inc., the interest tax shields and the value of the tax shield in the analysis, will     , leading to a      value of operations of the acquired firm. The APV approach is considered useful for valuing acquisition targets, because the method involves finding the values of the unlevered firm and the interest tax shield separately and then summing those values. Why is it difficult to value certain types of acquisitions using the corporate valuation model? The acquiring firm usually assumes the debt of the target firm. Thus, old debt with different coupon rates usually becomes a part of the acquisition deal. The acquiring firm immediately retires the target firm’s old debt. Thus, the acquisition deal consists of only new debt in its capital structure. (LOOKING FOR THE VALUE ANSWERS)

Answer 1

We will find the un -levered beta, using the equation

Levered beta=Unlevered beta*(1+((1-tax rate)*Debt/Equity)

1.40=Unlevered beta*(1+((1-0.30)*18.20/28)

Unlevered beta=1.40/((1+((1-0.30)*18.20/28))

0.9622

Now ,the unlevered cost of equity=

RFR+(UnL beta*Market risk premium)

ie. 3%+(0.9622*5.10%)

7.91%

Fig. in mlns	Year 1	Year 2	Year 3
EBIT	16	19.2	24
Tax at 30%	-4.8	-5.76	-7.2
EAT	11.2	13.44	16.8
Additions to Net operating capital(Last yr. -Current yr.)	-3.5	2.4	2.4
Unlevered cash flows	7.7	15.84	19.2
Horizon value of unlevered CFs(19.2*1.04)/(7.91%-4%)			510.6905
Total Unlevered cash flows	7.7	15.84	529.8905
PV F at 7.91%(1/1.0791^Yr.n)	0.92670	0.85877	0.79582
PV at the Unlevered cost of equity,7.91%	7.135576	13.60291	421.6976
Unlevered value of operations	442.436
Interest Tax shields(Int*30%)	1.5	1.65	1.8
Horizon value of tax shield at gross cost of debt(1.8*1.04)/(5%-4%)			187.2
Total Tax shields	1.5	1.65	189
PV F at 5.00%(1/1.05^Yr.n)	0.95238	0.90703	0.86384
PV at the gross cost of debt, 5%	1.428571	1.496599	163.2653
NPV of Tax shields at gross cost of debt	166.1905
Adjusted present value of operations	608.6265
Answers for the following from the above calcualtions:	mlns
Unlevered cost of equity	7.91%
Horizon value of unlevered cash flows	510.6905
Horizon value of tax shield	187.2
Unlevered value of operations	442.436
Value of tax shield	166.1905
Value of operations	608.6265
Less: value of debt	29
the total value of Galaxy Sun’s equity is	579.6265

Suppose RTE Telecom Inc. plans to use more debt in the first few years of the acquisition of Galaxy Sun Corp. Assuming that using more debt will not lead to an increase in bankruptcy costs for RTE Telecom Inc., the interest tax shields and the value of the tax shield in the analysis, will DECREASE , leading to a DECREASE in value of operations of the acquired firm.

Why is it difficult to value certain types of acquisitions using the corporate valuation model?

a. The acquiring firm usually assumes the debt of the target firm. Thus, old debt with different coupon rates usually becomes a part of the acquisition deal.