Question

As part of an LBO, Herb PE (HPE) intends to acquire Biggers Inc. (BI), an all-equity firm. BI is currently a public company, valued by the markets at $1.5B. Based on prior transactions, management believes the market is fairly valuing the business at $1.5B BUT to complete the deal, HPE will need to offer a 10% premium to acquire the business. The goal is to finance the price of the deal with 85% debt. After the transaction, HPE plans split BI into two divisions. The first, Division A, which the HPE analysts believe is worth $500M. The second division, Division B, is worth the remaining $1.0B. The plan is to sell Division B in one year for $1.2B, more than its current value of $1.0B – you may assume that all cash flows are after tax where necessary. HPE will use these proceeds, plus other capital to repay the debt. The debt charges interest at 8%. BI will pay taxes at a rate of 20%. The cost of equity for BI is 12%. This is a good unlevered cost of equity to use for your calculations. Given the premium HPE will pay over current market price, is this a good deal?

Answer 1

Market value of BI is $1500 million

After 10% premium the price the deal comes out to be = 1500×1.1 = $1650million

Now to check whether it is worth to pay premium ,we need to perform DCF analysis because worth or fair value of any asset or company = present value of its future cashflows

To calculate present value we need cost of capital WACC which os given by

WACC = We ×ke + Wd ×Kd

Where

Wd = porttion of debt on total funds = 85%

We = portion of equity in total funds which is = 1-.85 =15%

Ke = cost of equity = 12%

Kd = post tax cost of debt = interest rate×(1- tax rate) = 8%×(1-.20) = 6.4%

WACC = .15 ×12% +.85×6.4% = 7.24%

Now lets calculate the cashflows

BI after acquisition will be separated in two units A and B

A worth $500 now but we ate not given how much cash flows it will generate in future let us assume that this unit will takeup those projects which will provide returns = cost fo capital i.e. WACC so as to meet the requirements of shareholders and debtholders in such case post tax free cashflows from this unit will = initial investment × returns (which is=WACC)

= $500m×.0724 = $36.2m

And this unit won't be sold i.e. it will generate these cashflows perpetually and thr present value of a perpetual cashflow stream is

PV = cashflow/WACC = 60/.724= $500m

Unit B will be sold for $1200million

So the worth of this unit = PV of 1200 million @7.24%

PV if single cashflow = cashflow/(1+WACC)^n

Here n= 1 as the unit will bw sold after 1 year

PV= 1200/1.0724 = $1118.99

Total worth of BI = 1118.99 +500= $1618.99m

The maximum premium which HPE should pay = 1618.99-1500 = $118.99 million not 1650-1500=$150 million hence 10% premium is not justified.it is not a good deal.