Question 1 (40 Points)

1.a (20 points)

In a recent survey, most managers say that they determine the value of a target by estimating the expected post-merger cash flows that will accrue to their firm’s shareholders and then discounting such cash flows using their own WACC. What would be the main consequence of using this approach?  Please explain you answer.

2.a (20 points)

Companies A and B are valued as follows:

A

B

# of shares

              2,000

            1,000

Earnings per share

 $                20

 $              10

Share price

 $              100

 $              75

Given that the price-earnings ratio of Company B is 50% larger than the price-earnings ratio of Company A, would it be reasonable for Company A to pay a premium of 50% to acquire the shares of Company B?  Please explain your answer.

Question 2 (50 points)

Conglomerate Inc. has 20 million shares outstanding and its stock is currently trading at $25 a share.  The firm has two divisions: industrial electrical equipment and machine tools.  The following table provides financial information for each division (in millions of dollars):

Industrial Electrical Equipment

Machine Tools

Net Income

19.61

21.2

Sales

52.9

278.71

Book Value of Equity

134.83

279.32

EBITDA

17.46

49.44

Total Debt

7.33

55.01

Since the managers believe that both divisions are being undervalued by investors, they are considering a divestiture program.  To justify this program, the managers have collected the following data for several industrial electrical equipment and machine tools companies:

Industrial Electrical Equipment

Nidec

Eaton

Market Value of Equity/Sales

2.29

0.94

Market Value of Equity /Book Value of Equity

4.04

1.65

Enterprise Value/EBITDA

14.539

13.405

Enterprise Value/Sales

2.31

1.17

Total Debt

$1,430M

$3,470M

Price per Share

$24.53

$67.61

Number of Shares

557.17M

166.7M

Machine Tools

Kaydon

Stanley Works

Market Value of Equity/Sales

2.37

1.2

Market Value of Equity /Book Value of Equity

1.6

2.27

Enterprise Value/EBITDA

8.512

9.38

Enterprise Value/Sales

1.84

1.47

Total Debt

0

$1,380M

Price per Share

$33.70

$53.36

Number of Shares

33.23M

80.63M

Note: Enterprise value is equal to the market value of equity plus total debt.

Should the firm go ahead with the divestiture program?  Please justify your answer.

Question 3 (60 Points)

Company A has a market value of equity of $2,000 million and 80 million shares outstanding.  Company B has a market value of equity of $400 million and 25 million shares outstanding.  Company A announces at the beginning of 2019 that is going to acquire Company B. 

The projected pre-tax gains in operating income (in millions of $) from the merger are:

2019

2020

2021

2022

2023

Pre-tax Gains in Operating Income

12

16

28

38

45

The projected pre-tax gains in operating income are expected to grow at 4% after year 2023. The company is using a discount rate of 8% to value the synergies.  The marginal corporate tax rate is 35%.

Company A has decided to pay a $300 million premium for Company B.  Assume that capital markets are efficient and that there is a 100% probability the deal will be closed.

Question 3.1

30 Points

By how much the price per share of Company A would change at the time of the announcement of the acquisition?

Question 3.2

15 Points

If Company A were to make a 100% stock offer for Company B, what would the exchange ratio be?  Remember that the exchange ratio is the number of Company A’s shares that the shareholders of Company B will receive in exchange for each of their shares.

Question 3.3

15 Points

If Company A were to offer 0.80 share of Company A for each share of company B, by how much the price per share of Company A would change at the time of the announcement of the acquisition?

Question 4 (50 Points)

Company XYZ is analyzing the possible acquisition of a privately-held oil company called O&G Inc. The financial information for O&G is shown below:

Revenues in 2018

$30 million

COGS as % of revenues

64%

Tax rate on income

35%

Depreciation as % of revenues

2.25%

CAPEX as % of revenues

3%

Working capital as % of revenues

2%

Company XYZ estimates that it can increase O&G’s free cash flows by reducing operating costs and capital expenditures.  They estimate the following savings:

2019-2021

After 2021

COGS as % of revenues

58%

54%

CAPEX as % of revenues

1%

0.50%

It is expected that the revenues of O&G will grow at a rate of 2.5% over the period 2019-2021 and then at a constant rate of 2% after the year 2021.  O&G has no debt.

Since O&G is privately-held, its equity beta is not available. However, analysts at Company XYZ believe that ConocoPhillips (COP) and Chevron (CVX) can be used as comparable firms.  Below is the the financial information for these two firms:

Beta

Debt                        (Billions of $)

Book Value of Equity (Billions of $)

Market Value of Equity (Billions of $)

ConocoPhillips

0.98

14.97

31.93

79.96

Chevron

0.91

36.11

153.57

227.65

Assume that the market risk premium is 6.5%, the risk free-rate is 5%, the cost of debt is 5%, and that the CAPM holds.  Further, assume that you are doing the valuation at the beginning of 2019.

Company XYZ has a market value of equity of $850 million and 40 million shares outstanding.

a) (30 points) If Company XYZ wants to capture 30% of the synergies, what should be the premium that it should pay for O&G?

b) (20 points) )  If Company XYZ were to make a 40% stock and 60% cash offer for O&G and both firms decide to share the synergies equally, how many shares of Company XYZ would the target shareholders receive?

Question 5 (40 Points)

XYZ is an unlevered firm and is currently valued at $820,000. It has 15,000 shares outstanding. As part of a Management Buyout (MBO), XYX is planning to borrow $400,000 from a bank at an annual interest rate of 5.5%. XYZ would repurchase $400,000 worth of stock with the proceeds of the bank loan. The bank agreement stipulates that the debt be repaid according to the following 6-year amortization schedule:

Beginning

Ending

Year

Balance

Payment

Interest

Principal

Balance

1

4,00,000.00

80,071.58

22,000.00

58,071.58

3,41,928.42

2

3,41,928.42

80,071.58

18,806.06

61,265.52

2,80,662.90

3

2,80,662.90

80,071.58

15,436.46

64,635.12

2,16,027.78

4

2,16,027.78

80,071.58

11,881.53

68,190.05

1,47,837.73

5

1,47,837.73

80,071.58

8,131.08

71,940.50

75,897.23

6

75,897.23

80,071.58

4,174.35

75,897.23

0.00

At the end of year 6, XYZ will issue $200,000 in new debt.  The firm plans to keep this debt level in perpetuity.   The current cost of equity is 10% and the corporate tax rate is 35%.  If capital markets are efficient, by how much the price per share of Company XYZ would change at the time of the announcement of the MBO?