Question

MERGER ANALYSIS Apilado Appliance Corporation is considering a merger with the Vaccaro Vacuum Company. Vaccaro is a publicly traded company, and its current beta is 1.30. Vaccaro has been barely profitable, so it has paid an average of only 20% in taxes during the last several years. In addition, it uses little debt, having a debt ratio of just 25%. If the acquisition were made, Apilado would operate Vaccaro as a separate, wholly owned subsidiary. Apilado would pay taxes on a consolidated basis, and the tax rate would therefore increase to 35%. Apilado also would increase the debt capitalization in the Vaccaro subsidiary to 40% of assets, which would increase its beta to 1.47. Apilado’s acquisition department estimates that Vaccaro, if acquired, would produce the following cash flows to Apilado’s shareholders (in millions of dollars):

Year 1 2 3 4 5 and beyond

Cash Flows $1.30 1.50 1.75 2.00 Constant growth at 6%

These cash flows include all acquisition effects. Apilado’s cost of equity is 14%, its beta is 1.0, and its cost of debt is 10%. The risk-free rate is 8%.

a. What discount rate should be used to discount the estimated cash flows? (Hint: Use Apilado’s rs to determine the market risk premium.)

b. What is the dollar value of Vaccaro to Apilado?

c. Vaccaro has 1.2 million common shares outstanding. What is the maximum price per share that Apilado should offer for Vaccaro? If the tender offer is accepted at this price, what will happen to Apilado’s stock price?

Answer 1

a. Calculation of discount rate

To calculate the discount rate to be used to discount the estimated cash flows, we need to first calculate the Cost of Equity after Acquistion, for which we will require the Market Risk Premium.

By CAPM,
Cost of Equity = Rf + (Rm - Rf) * Beta
Apilado’s cost of equity before merger is 14%
Therefore, 14 = 8 + (Rm - 8) * 1
14 = 8 + Rm - 8
Rm = 14
Therefore, Market Risk Premium = 14%

Therefore, New Cost of Equity after Merger = 8 + (14 - 8) * 1.47
= 8 + 8.82
Therefore, Cost of Equity after Merger = 16.82%
After Tax Cost of Debt = 10 * (1-0.35) = 6.5%

Debt to Equity is 40:60
Therefore, WACC = (0.4 * 6.5) + (0.6 * 16.82)
= 12.69%

Therefore, the discount rate should be used to discount the estimated cash flows is 12.69%

b. Computation of dollar value of Vaccaro to Apilado

Dollar Value = Present Value of Cash Flow Estimates of (Year 1 + Year 2 + Year 3 + Year 4 + Terminal Value)

Terminal Value = D5 / (Wacc - g)
= (2 * 106%) / (12.69 - 6)
= 2.12 / (6.69%)
= $31.69million

Therefore, Dollar Value = [(1.3 / 1.1269) + (1.5 / 1.1269^2) + (1.75 / 1.1269^3) + (2 / 1.1269^4) + (31.69 / 1.1269^4)]
= $24.45 million

Therefore, the dollar value of Vaccaro to Apilado is $24.45 million

c. Vaccaro has 1.2 million shares outstanding
Therefore, maximum price per share that Apilado should offer for Vaccaro = 24.45 / 1.2
= $20.375

At this price, since Apilado is paying exactly what Vaccaro is worth Apilado's price should remain constant.
Therefore, Apilado's stock price will remain the same.