Question

*please show work thank you

MERGER ANALYSIS TransWorld Communications Inc., a large telecommunications company,
is evaluating the possible acquisition of Georgia Cable Company (GCC), a regional
cable company. TransWorld’s analysts project the following post-merger data for GCC (in
thousands of dollars):
                                                      2015 2016 2017 2018
Net sales                                     $450 $518 $555 $600
Selling and administrative expense    45     53       60     68
Interest                                               18      21      24 27
Tax rate after merger 35%
Cost of goods sold as a percent of sales 65%
Beta after merger 1.50
Risk-free rate 8%
Market risk premium 4%
Continuing growth rate of cash flow available to
TransWorld 7%
If the acquisition is made, it will occur on January 1, 2015. All cash flows shown in the
income statements are assumed to occur at the end of the year. GCC currently has a
capital structure of 40% debt, but Trans World would increase that to 50% if the
acquisition were made. GCC, if independent, would pay taxes at 20%; but its income
would be taxed at 35% if it were consolidated. GCC’s current market-determined beta
is 1.40, and its investment bankers think that its beta would rise to 1.50 if the debt ratio
were increased to 50%. The cost of goods sold is expected to be 65% of sales, but it
could vary somewhat. Depreciation-generated funds would be used to replace wornout
equipment, so they would not be available to TransWorld’s shareholders. The riskfree
rate is 8%, and the market risk premium is 4%.
a. What is the appropriate discount rate for valuing the acquisition?
b. What is the continuing value?
c. What is the value of GCC to TransWorld?

Answer 1

a). Appropriate discount rate will be the cost of equity for GCC after the merger.

Using CAPM, cost of equity = risk-free rate + beta*market risk premium

= 8% + (1.5*4%) = 14%

Formula	Year (All numbers in $'000s except %age)	2015	2016	2017	2018	2019
	Time period (n)	1	2	3	4	Terminal
	Growth rate (g)					7%
	Net sales	450.00	518.00	555.00	600.00
65%*Sales	COGS	292.50	336.70	360.75	390.00
	SG&A	45.00	53.00	60.00	68.00
	Interest expense	18.00	21.00	24.00	27.00
	EBT	94.50	107.30	110.25	115.00
	Tax @ 35%	33.08	37.56	38.59	40.25
	Net income	61.43	69.75	71.66	74.75	79.98
FCFEterminal/(k-g); k = 14%, g = 7%	Terminal value					1,142.61
	FCFE	61.43	69.75	71.66	74.75	1,142.61
1/(1+k)^n	Discount factor @ 14%	0.877	0.769	0.675	0.592	0.592
(FCFE*Discount factor)	PV of FCFE	53.88	53.67	48.37	44.26	676.52
Sum of all PVs	Total equity value	876.69

b). Continuing value (or terminal value) = 1,142,607.14

c). Value of GCC to Transworld = 876,691.39