Question

Using the Adjusted present value (APV) approach:

BTR Warehousing, which is considering the acquisition of Globo-Chem Co., estimates that acquiring Globo-Chem 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	$11.0	$13.2	$16.5
Interest expense	3.0	3.3	3.6
Debt	34.1	40.3	43.4
Total net operating capital	105.1	107.1	109.1

Globo-Chem Co. is a publicly traded company, and its market-determined pre-merger beta is 1.60. You also have the following information about the company and the projected statements:

•	Globo-Chem currently has a $16.00 million market value of equity and $10.40 million in debt.
•	The risk-free rate is 5%, there is a 7.10% market risk premium, and the Capital Asset Pricing Model produces a pre-merger required rate of return on equity rsLsL of 16.36%.
•	Globo-Chem’s cost of debt is 7.00% 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 $102.0, and the sum of existing debt and debt required to maintain a constant capital structure at the time of acquisition is $31 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	12.67% (other choices: 9.2%, 14.16%, 10.69%)
Horizon value of unlevered cash flows	(110.5, 114.56, 53.06, 86.85)
Horizon value of tax shield	(12.96, 12.46, 11.88, 20.76)
Unlevered value of operations	(95.47, 96.55, 61.40, 90.85)
Value of tax shield	(50.60, 11.40, 15.62, 61.58)
Value of operations	Value of operations: (157.05, 112, 106.47, 107.95) Thus, the total value of Globo-Chem’s equity is (146.65, 86.15, 51, 97.55). Suppose BTR Warehousing plans to use more debt in the first few years of the acquisition of Globo-Chem Co. Assuming that using more debt will not lead to an increase in bankruptcy costs for BTR Warehousing, the interest tax shields and the value of the tax shield in the analysis, will (decrease/increase) , leading to a (higher/lower) 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? 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. B) The acquiring firm immediately retires the target firm’s old debt. Thus, the acquisition deal consists of only new debt in its capital structure.

Answer 1

Answers highlighted in bold

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Unlevered cost of equity:

D = 10.40; E = 16; Total capital, C = D + E = 10.4 + 16 = 26.4

Wd = D / C = 10.4 / 26.4 = 39.39%

We = 1 - Wd = 1 - 39.39% = 60.61%

r_SL = 16.36%; r_D = 7%

Hence, unlevered cost of equity, k = Wd x r_D + We x r_SL = 39.39% x 7% + 60.61% x 16.36% = 12.67%

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Horizon value of unlevered cash flows  

Parameter	Linkage	Year 0	Year 1	Year 2	Year 3
EBIT			11.00	13.20	16.50
Tax rate, T			30%	30%	30%
Total net operating capital	A	102.00	105.10	107.10	109.10
Increase in net operating capital	B = Difference of successive A's		3.10	2.00	2.00
Unlevered free cash flows	EBIT x (1 - T) - B		4.60	7.24	C3 = 9.55

Horizon value of unlevered cash flows = C3 x (1 = g) / (k - g) = 9.55 x (1 + 4%) / (12.67% - 4%) =  114.56

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Horizon value of tax shield

Parameter	Linkage	Year 0	Year 1	Year 2	Year 3
Interest expense	I		3.00	3.30	3.60
Interest tax shield	I x (1 - T)		0.90	0.99	ITS3 = 1.08

Horizon value of tax shield = ITS3 x (1 + g) / (k - g) = 1.08 x (1 + 4%) / (12.67% - 4%) = 12.96

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Unlevered value of operations = PV of all the future unlevered cash flows = 96.55 (Please see the working below)

Parameter	Linkage	Year 0	Year 1	Year 2	Year 3
Unlevered free cash flows	A		4.60	7.24	9.55
Horizon value	B				114.56
Discount factor	C = (1 + 12.67%)^(-n)		0.8875	0.7877	0.6991
PV of unlevered cash flows	D = A x C		4.08	5.70	6.68
PV of horizon value	E = B x C				80.09
Unlevered value of operations	Sum of all D's & E	96.55

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Value of tax shields = 11.40

Parameter	Linkage	Year 0	Year 1	Year 2	Year 3
Interest tax shield	A		0.90	0.99	1.08
Horizon value	B				12.95
Discount factor	C = (1 + 12.67%)^(-n)		0.8875	0.7877	0.6991
PV of Interest Tax shield	D = A x C		0.80	0.78	0.76
PV of horizon value	E = B x C				9.05
Value of tax shields	Sum of all D's & E	11.40

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Value of operations, V =Unlevered value of operations + Value of tax shields = 96.55 + 11.40 = 107.95

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the total value of Globo-Chem’s equity is = V - D = 107.95 - 10.40 = 97.55

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Suppose BTR Warehousing plans to use more debt in the first few years of the acquisition of Globo-Chem Co. Assuming that using more debt will not lead to an increase in bankruptcy costs for BTR Warehousing, the interest tax shields and the value of the tax shield in the analysis, will increase , leading to a higher value of operations of the acquired firm.

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The correct answer is the second option i.e. option B) The acquiring firm immediately retires the target firm’s old debt. Thus, the acquisition deal consists of only new debt in its capital structure.