Question

Acquisitions Inc is a brick and mortar retail company. Acquisition’s management believes that the company needs to establish an on-line presence in order to remain viable. For that reason, Acquisition would like to purchase Target Company, an on-line company in a similar line of business. Acquisition believes that Target would also benefit from the merger by gaining access to a brick and mortar outlet.

Some basic information about Acquisition and Target follows:

	2018		2018
	Acquisition		Target
Revenues	30000		20000
Cost of Goods Sold	24000		16000
Depreciation	4500		1000
EBIT*(1-T)	1200		2400
Capex	1500		1000
Working Capital	300		200
Working Capital 2017	200		150
Levered β (Equity)	1.8		0.9
MV Debt	23400		6700
MV Equity	35000		27000
Tax Rate	0.2		0.2
Pre-tax cost of debt	4.2		3.5
FCF growth rate	0.03		0.05

                               

Analysts hired by Acquisition to value the merger estimate that if the two companies merge, their combined revenues will increase by 5 percent for 3 years and for 3% thereafter. Cost of Goods Sold for the combined firms will be permanently reduced by 2%. assume the market risk premium is 5.5%, the risk free interest rate is 2% and the corporate tax rate is 0.20.

Please find:

1. The status-quo values of Acquisition and Target, using each firm’s WACC to value its assets.
2. The WACC for the combined firm
3. The value of the combined firm with potential synergies considered.
4. Should the merger take place?

Answer 1

Q1: Find the value of the firs acquisition and target

For this we apply the formula to value a firm

Formula: Value of a firm(VF)=FCFF(1+g)WACC-g

Here, FCFF- Free cash flow to the firm

WACC- Weighted average cost of capital

g- growth rate

To find VF, we need to find FCFF and WACC

Lets start with Acquisition Ltd

FCFF=Net Income(before dividend)+Non cash expenses(Depreciation)+Interest(after tax)- Cap expenditure(Capex)- change in working capital

So using the formula we get,

FCFF=1200+4500+(The income given is before interest so no need to add back interest)-1500-100

   =4100

Cost of equity=Rf+(Rm-Rf)

=2+1.8(5.5-2)

   =8.3%

WACC=8.3*(35000/58400)+4*(23400/58400)

   =6.58%

Vf=4100(1+0.03)/(0.0658-0.03)

=117960

In the same manner calculate Value of target,

we get Vf=1900(1+0.05)/(0.0478-0.05)

Q2:WACC for the combined firm

Cost of equity=Rf+(Rm-Rf)

=2+1.4(5.5-2)

   =6.9%

WACC=6.9*(62000/92100)+3.83*(30100/92100)

   =5.89%

is assumed to be average of both the companies for calculating cost of equit. And also cost of debt is assumed to be average of the two companies.

Q3: calculate using the same method by using the revised figures

Hope this helps:)