Question

Pampa RV, Inc. is considering the acquisition of Chico Clothing Company (CCC) for a price of $12 per share. Pampa’s has 500,000 shares of common stock outstanding, currently trading at $9.75 per share. The book value of the common stock is $5 per share. Pampa also has bonds with a market value of $3,500,000 and a yield to maturity of 3.4%. Based on current market valuations, Pampa is currently achieving its target debt to equity ratio. Pampa’s equity beta is 0.80.

CCC’s cost of goods sold (COGS) is expected to be 38% of sales revenues, and selling, general and administrative (SG&A) expenses are expected to be 12% of revenues. The firm is 100% equity financed and has 100,000 shares of common stock outstanding. Its equity beta is estimated to be 1.353.

CCC has experienced rapid growth over the last ten years. However, your analysis of industry structure suggests that competition in the beauty pageant clothing and accessories market is likely to increase in the next few years. Thus, you forecast that the perpetual growth rate for free cash flows after five years will be a modest 1.5% per year. The corporate tax rate is 40% for all firms.

Table 1: Forecast Data for Chico Clothing Company Year
	Year 1	Year 2	Year 3	Year 4	Year 5
Sales Revenue	300,000	335,000	375,000	410,000	575,000
Investment in CapEx and NWC	18,000	25,000	40,000	50,000	65,000
	15,000	30,000	40,000	52,000	60,000
Depreciation

Table 2 Market Data Current yield to maturity on 30 year treasury bonds	2.50%
Estimate of expected average return on the S&P 500 over the next 30 years	7.50%

1) What is the value of Chico Clothing Company? Assume that your valuation is performed today at Year 0, and that the revenues shown in Table 1 are end-of-year year forecasts.

2) Suppose Pampa RV offers to pay $12 for each of CCC’s outstanding shares. If the market fully impounds this information, what will be the new price per share of Pampa’s common stock?

3) What is the most that Pampa should pay for CCC? Why?

4) Estimate the beta of the combined entity (Pampa + CCC) after the merger. Based on your answer, will the merged firm’s cost of capital to be higher or lower than Pampa’s current cost of capital? Explain your answer. Hint: Firm beta is a value-weighted average of individual betas.

Answer 1

Year	1	2	3	4	5
1.Sales Revenue	300,000	335,000	375,000	410,000	575,000
2.Less: COGS(sales*38%)	-114,000	-127,300	-142,500	-155,800	-218,500
3.Less: S,G&A(Sales *12%)	-36,000	-40,200	-45,000	-49,200	-69,000
4.EBIT(1+2+3)	150,000	167,500	187,500	205,000	287,500
5.Less:Tax at 40%(4*40%)	-60,000	-67,000	-75,000	-82,000	-115,000
6. Add:Depreciation	15,000	30,000	40,000	52,000	60,000
7.Less:Investment in CapEx and NWC	-18,000	-25,000	-40,000	-50,000	-65,000
8.FCF(4+5+6+7)	87,000	105,500	112,500	125,000	167,500
9.Terminal FCF(FCF6/(WACC-g))(167500*1.015)/(9.27%-1.5%)=					2,188,063
10. Total FCF(8+9)	87,000	105,500	112,500	125,000	2,355,563
11.PV F at 9.27%(1/1.0927^Yr.n)	0.91516	0.83753	0.76647	0.70145	0.64194
12.PV at 9.27%(10*11)	79619	88359	86228	87681	1512133
13.NPV(sum of Row 12)(CCC's Value)	1,854,021
14. No.of common shares o/s	100,000
15. Value /share for CCC(13/14)	18.54
ANSWER:1) Value of Chico Clothing Company=		1,854,021

CCC's WACC to discount its FCFs=is its cost of equity

which is as per CAPM,

ke=RFR+(Beta*(Market return-RFR))

ie.2.5%+(1.353*(7.5%-2.5%))

9.27%

2..Market value of Pampa's equity(500000*9.75)	4875000
Add: Market value of bonds	3500000
Total Pampa's Firm value	8375000
Less: Cash paid for CCC's shares(100000*12)	-1200000
New firm value	7175000
less: Market value of bonds	-3500000
Market value of equity	3675000
No.of equity shares o/s	500000
New Price/share of Pampa = $	7.35

3..Pampa's WACC
	Mkt.value	Wt.to total
MV of equity	4875000	58.21%
MV of debt	3500000	41.79%
Total capital	8375000	100%
Pampa's cost of rquity as per CAPM=
2.5%+(0.8*(7.5%-2.5%))=
6.50%
WACC(Pampa) =
(41.79%*3.4%*(1-40%))+(58.21%*6.5%)=
4.64%

3. Maximum Pampa should pay for CCC is the latter's FCFs discounted at its own WACC
10. Total FCF(8+9)	87000	105500	112500	125000	2355563
11.PV F at 4.64%%(1/1.0464^Yr.n)	0.9557	0.9133	0.8728	0.8341	0.7971
12.PV at 9.27%(10*11)	83142	96351	98188	104260	1877613
13.NPV(sum of Row 12)	2259555