In: Finance
Banana Tires (BT), a U.S.-based multi-national company, has screened several acquisition targets in Malaysia. BT has identified a Malaysian company, KL Rubber, which would provide a good strategic fit for BT. The estimates for revenue for the next year are MYR 200 million. Revenues are expected to increase by 6% into the foreseeable future (in MYR).
Expenses are expected to be 65% of revenue. The tax rate on the firm's earnings is expected to be 35%. Assume that there is no depreciation.
This exchange rate is currently $.2255 per MYR. Inflation is expected to average 6.5% in Malaysia and 2.0% in the U.S. BT has estimated their cost of capital for this project to be 12.5% (in terms of USD).
What is the maximum that BT should pay for KL Rubber? (4 points)
Valuation of KL Rubber:
Cost of capital for this project (Kc) = 12.5%
Growth in US $ terms = 1.52%
KL Rubber can be valued using discounted earnings approach:
= Estimated earnings after tax / (Kc - g) = 9,826,635 / (12.5% - 1.52%) = $89,495,765.03
Hence, the maximum amount that BT should pay for KL Rubber is $89,495,765.03
Notes:
1. Calculation of 1 year forward exchange rate using Purchase Price Parity:
Forward rate = Current exchange rate * [(1 + Inflation rate in US) / (1+ Inflation rate in Malaysia)]
where:
Current exchange rate : MYR 1 = $0.2255
Inflation rate in US = 2% = 0.02
Inflation rate in Malaysia = 6.5% = 0.065
Putting values in the formula, we get:
Forward rate = 0.2255 * [(1 + 0.02) / (1+ 0.065)] = $0.21597 per MYR
2. Converting estimated revenue into US dollars:
Estimated revenue next year = MYR 200 million
Estimated revenue next year in $ terms = MYR 200 million * Forward rate = 200 million * 0.21597 = $43.194 million
3. Calculation of cash flows from KL Rubber:
Estimated revenue = $43,194,000
Less : Estimated expenses (65%) =$28,076,100
EBT =$15,117,900
Less : Estimated Taxes at 35% =$5,291,265
Estimated earnings after tax =$9,826,635
4. Inflation adjusted Growth rate in US $ terms:
= {[(1 + Growth in MYR) / (1+ Inflation rate in Malaysia)] * (1 + Inflation rate in US)} - 1
= {[(1+ 0.06) / (1 + 0.065)] * (1 + 0.02)} - 1 = 1.52%