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Homework answers / question archive / Pharma Inc , a listed pharmaceutical company, has a total of $50 million (market value) of debt outstanding and its stock is traded at $200 million in the market

Pharma Inc , a listed pharmaceutical company, has a total of $50 million (market value) of debt outstanding and its stock is traded at $200 million in the market

Economics

Pharma Inc , a listed pharmaceutical company, has a total of $50 million (market value) of debt outstanding and its stock is traded at $200 million in the market. The beta for its equity is 0.8 and the beta for its debt is 0.2. Pharma Inc. is thinking of diversifying into other businesses and has just identified an acquisition target, Food Link. Food Link is currently privately held, with 1 million stock shares outstanding, held mostly by the founding family. It has a stable after tax earnings of $6.6 per share per year, which is all paid out as dividends. This situation is expected to continue forever. There is a listed company in the same food business, Food Connection, with the following information: 
Equity ($ Million) Debt ( $ Million) Βeta E Βeta D
Food Connection 180 120 0.80 0.30
Assume no corporate or personal taxes. Assume the CAPM holds. Let the risk-free rate be 3%, the market risk premium is 6%
i) What is the required rate of return on Parma Inc.'s assets? 
ii) What should be the right cost of capital for Food Link? What is the highest price Pharma Inc. should offer? 
iii)  How should Parma Inc. finance this purchase, all equity or an optimal mix of equity and debt? If there is an optimal capital structure, please determine what it is. Explain your answers
Suppose all the information remains the same as in the questions above, except that the corporate tax rate is 30%, personal tax is still zero and $6.6 is the after-tax earnings of Food Link. Assume that both Parma Inc. and Food Connection are at their optimal leverage ratios. 
iv) What leverage ratio (D/V) should we choose for the purchase of Food Link? Explain
Next, compute the highest offer price using APV.
v) What is the value of the unlevered Food Link (VU ) now? Notice that the numbers in the table would imply a different required return on assets now due to the taxes.
vi) Compute the highest offer price using APV. (Hint: VU +τD = E + D ⇒ VU = E + (1 − τ ) D = D 1 − τ + E D

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