Question

4. TTT Corp is evaluating the acquisition of KT Company.  TTT analyst projects the following post merger cash flows for KT Company if purchased by TTT Corp.

Net Sales

Year 1 $600 Year 2 $700      

Oper Expenses       

Year 1 $350 Year 2 $400        

Interest

Year 1 20 Year 2 25        

Depreciation

Year 1 10 Year 2   10         

Net Investment

Year 1 10 Year 2  10         

In Operating Capital

The current market beta for KT Company is 1.4 and its tax rate is 25% and debt ratio of 40%. TTT Corp has a tax rate of 25%.  Assume a market return of 10% and a risk free rate of 4%.

a. What is the appropriate discount rate to use in calculating the value of the acquisition? (Use the Adjusted Present Value Approach).

b. What are the free cash flows for the two years and tax shield for two years?

c. If we assume constant growth of 5% from beyond Year 2, calculate the horizon value of free cash flows and the horizon value of tax shield flows.

d. Find the value of the operations of the target.  Assume no non-operating assets.

e. If the market value of debt is $300 and there is no preferred stock, find the maximum price per share that should be offered for the target.  Assume there 100 shares of stock.

Answer 1

a. The discount rate shall be the Weighted Average Cost of Capital, comprising of expected rate of return by the investors and Debt Interest rate. Ex shall be calculated by employing CAPM Model.

Ex = Risk Free rate + Beta Average (Market return - Risk free rate)

= 4 + 1.4*(10-4)

= 12.4%

Debt Interest (Post tax) will be taken at Risk Free rate as no seperate interest is given in the question.

Dx = 4*(0.75) = 3%

Particulars	rate	Weights	Weighted Return
Stock	12.40	0.6	7.44
Debt	3	0.4	1.2
WACC			8.64 %

b. Free Cash flow helps the investors in assessing the financial health of the company as it involves calculating net infloe after deducting all the operating expenses, non operating expenses and capital expenditures from the revenue.

Free Cash Flows for 2 years

Particulars	Year 1	Year 2
Net Sales	600.00	700.00
Less:
Operating Expenses	350.00	400.00
Interest	20.00	25.00
Depreciation	10.00	10.00
Profit Before tax	220.00	265.00
Tax @25%	55.00	66.25
Profit After tax	165.00	198.75
Add: Depreciation	10.00	10.00
Change in Operating Capital	10.00	10.00
Free Cash Flows	165.00	198.75

Tax Shield is the reduction in the outflow of funds owing to the rax benefit received on the account of deductions on depreciation and other non cash expenses charged on revenue.

Particulars	Year 1	Year 2
Profit Before tax	220.00	265.00
Add: Depreciation	10.00	10.00
Profit Before Charging Depreciation	230.00	275.00
Tax @25%	57.50	68.75
Profit After tax (when depreciation is not charged)	172.50	206.25
Profit After tax (in normal scenario)	165.00	198.75
Tax Shield	7.50	7.50

c. Terminal Value is calculated by assuming that the growth rate will continue perpetually and thus the future value of the all the cash flows is calculated and brought to present value.

Terminal Value of FCF = [FCF x (1+g)] / (WACC - g)*(1+WACC)^2]

= [198.75*(1+0.02) / (0.0864-0.02)*((1+0.0864))^2]

= $ 2,586.78

Terminal Value of Tax Shield = Constant Tax Shield / (WACC - g)*(1+WACC)^2

= 7.5 / (0.0864-0.02)*((1+0.0864))^2

= $ 95.7

d. Operations of the Budget is calculated as the present value of the FCFs and the terminal value of the FCFs.

Operations of the Budget = PV of Free Cash Flows + Terminal Value

Particulars	Year 1	Year 2
Free Cash Flows	165	198.75
DCF @ 8.64%	0.9205	0.8473
PV of Free Cash Flows	151.88	168.39

= 151.88 + 168.39 + 2,586.78

= $ 2,907.05

e. Price of the stock

Particulars	Amount ($)
Value of the Firm	2907.05
Debt	300
Value of Equity	2607.05
No. of Shares	100
Maximum Price per Share	26.07