CHAPTER 25

MERGERS, LBOs, DIVESTITURES, AND HOLDING COMPANIES

(Difficulty: E = Easy, M = Medium, and T = Tough)

True-False
Easy:
Synergistic merger
1

Answer: a

Diff: E

In a synergistic merger, the post-merger value exceeds the sum of the

separate companies' pre-merger values.
a. True
b. False

Sources of synergy
2

Answer: a

Diff: E

Synergistic merger effects can arise from a number of different sources

including operating economies of scale, financial economies, and
increased managerial efficiency.
a. True
b. False

Spin-off
3

Answer: b

Diff: E

A spin-off is a type of divestiture in which the assets of a division

are sold to another firm.
a. True
b. False

Holding companies
4

Answer: b

Diff: E

The two principal advantages of holding companies are (1) that the
holding company can control a great deal of assets with limited equity
and (2) that the dividends received by the parent from the subsidiary
are not taxed if the parent holds at least 50 percent of the
subsidiary's stock.
a. True
b. False

Defensive mergers
5

Most defensive mergers occur

maximize shareholder's wealth.

Answer: b
as

result

of

managers'

Diff: E

actions

to

a. True
b. False

Chapter 25 - Page 1

Conglomerate merger
6

Answer: b

Diff: E

A conglomerate merger occurs when two firms combine that have both
horizontal and vertical business relationships.
a. True
b. False

Merger analysis
7

Answer: a

Diff: E

Since the basic rationale for any operating merger is synergy, in

planning such mergers, the development of accurate pro forma cash flows
is the single most important aspect of the analysis.
a. True
b. False

Merger terms
8

Answer: a

Post-merger control and the negotiated price are two

important issues in agreeing on the terms of a merger.

of

Diff: E
the

most

a. True
b. False
Defensive tactics
9

Answer: a

Diff: E

A company seeking to fight off a hostile takeover might employ the

services of an investment banking firm to develop a defensive strategy.
a. True
b. False

Poison pill defense

10

Answer: a

Diff: E

Borrowing funds on terms that would require immediate repayment of all

funds if the firm is acquired or selling off valuable assets are two
methods of defending against hostile takeovers.
These strategies are
known as poison pill defenses.
a. True
b. False

Chapter 25 - Page 2

Joint venture
11

Answer: a

Diff: E

A joint venture is one in which two, or sometimes more, independent

companies agree to combine resources in order to achieve a specific
objective, usually limited in scope.
a. True
b. False

Leveraged buyout
12

Answer: a

Diff: E

Leveraged buyouts (LBOs), popularized in the 1980s, occur when a firm's

managers decide to try and gain control of their publicly owned company
by buying out existing shareholders using large amounts of borrowed
money.
a. True
b. False

Mergers and interest rates

13

Answer: b

Diff: E

Mergers are more likely to occur when interest rates are high because
target firms can expect to get a higher premium in the acquisition
price.
a. True
b. False

Merger accounting
14

Mergers can be accounted for using either the

accounting or the pooling method of accounting.

Answer: b
purchase

Diff: E

method

of

a. True
b. False
Merger accounting
15

Answer: b

Diff: E

Goodwill created in a merger must be amortized over its expected life,

usually 40 years, for shareholder reporting purposes.
a. True
b. False

Merger accounting
16

Answer: a

Diff: E

Although goodwill created in a merger may not be amortized for

shareholder reporting purposes, it may be amortized for Federal tax
purposes.
a. True
b. False

Chapter 25 - Page 3

Medium:
Holding company advantages
17

Answer: b

Diff: M

The three main advantages of holding companies are (1) control with
fractional ownership, (2) taxation benefits, and (3) isolation of
operating risks.
a. True
b. False

International mergers
18

Answer: a

Diff: M

One of the main reasons why foreign firms are interested in buying U.S.
companies is to gain entrance to the U.S. market.
A decline in the
value of the dollar relative to most foreign currencies makes this
competitive strategy more feasible.
a. True
b. False

Merger cash flows

19

Answer: b

Diff: M

Discounted cash flow methods are not appropriate for evaluating mergers
because the cash flows are uncertain and the discount rate can only be
determined after the merger is consummated.
a. True
b. False

Relevant merger cash flows

20

Answer: a

Diff: M

In a financial merger, the relevant post merger cash flows are simply
the sum of the expected cash flows of the two companies measured as if
they were to be operated independently.
a. True
b. False

Financial merger
21

Answer: a

Diff: M

Coca-Cola's acquisition of Columbia Pictures and its announcement that

it would operate its new subsidiary separately could be described as
primarily a financial merger.
a. True
b. False

Chapter 25 - Page 4

Two-tier offer
22

Answer: b

Diff: M

A two-tier merger offer is one in which the acquiring company offers to

purchase the target company in a two-part transaction. Cash is paid to
some stockholders, bonds are issued to others, but the total values of
each part of the transaction are equal.
a. True
b. False

Vertical merger
23

Answer: a

Diff: M

If a petrochemical firm merged with an oil producer which had assets

including oil reserves, a refinery, and a drilling subsidiary, this
would be an example of a vertical merger.
a. True
b. False

Congeneric merger
24

Answer: a

Diff: M

A congeneric merger is one where the merging firms operate in related

businesses but do not necessarily produce the same products or have a
producer-supplier relationship.
a. True
b. False

Merger motivation
25

The purchase of assets at below

considerations
are
two
factors
historically.

Answer: a
their
that

replacement cost
have
stimulated

Diff: M
and tax
mergers

a. True
b. False
Merger motivation
26

Answer: b

Diff: M

The primary motivation for most mergers is to acquire more assets so as

to increase sales and market share.
a. True
b. False

Managerial control
27

Answer: b

Diff: M

Since managers' central goal is to maximize stock price, managerial

control issues do not interfere with mergers that would benefit the
target firm's stockholders.
a. True
b. False

Chapter 25 - Page 5

Managerial opposition
28

Answer: b

Diff: M

Since managers' central goal is to maximize stock price, any merger

offer which provides stockholders with significant gains over the
current stock price will not be opposed by incumbent management.
a. True
b. False

Merger discount rate

29

Answer: b

Diff: M

The discount rate used to discount projected merger cash flows should be
the cost of capital of the new consolidated firm because it incorporates
the actual capital structure of the new firm.
a. True
b. False

Synergistic gain
30

Answer: b

Diff: M

The distribution of the synergistic gain between the stockholders of two

merged firms is determined by their respective market values before they
merged.
a. True
b. False

Merger analysis
31

Answer: a

Diff: M

Only if a target firm's value is greater to the acquiring firm than the
target's market value as a separate entity will the merger be
financially justified.
a. True
b. False

Merger analysis
32

Answer: b

Diff: M

If the capital structure is stable and free cash flows are growing at a
constant rate at the horizon, then the horizon value is calculated by
discounting the free cash flows plus the expected future tax shields at
the weighted average cost of capital.
a. True
b. False

Merger analysis
33

Answer: a

Diff: M

The present value of the free cash flows discounted at the unlevered
cost of equity is the value of the firms operations if it had no debt.
a. True
b. False

Chapter 25 - Page 6

Multiple Choice: Conceptual

Easy:
Merger tactics
34

Firms use defensive tactics to fight off undesired mergers.

tactics include
a.
b.
c.
d.
e.

Answer: e

Diff: E

Synergistic benefits arising from mergers.

Reduction in competition resulting from mergers.
Attempts to stabilize earnings by diversifying.
All of the above.
Both a and c above.

Defensive strategies
.

These

Which of the following are given as reasons for the high level of merger
activity in the U.S. during the 1980s?
a.
b.
c.
d.
e.

36

Diff: E

Raising antitrust issues.

Taking poison pills.
Getting a white knight to bid for the firm.
Repurchasing their own stock.
All of the above.

Mergers
35

Answer: e

Answer: d

Diff: E

Which of the following actions assist managers in defending against a

hostile takeover?
a. Establishing a poison pill provision.
b. Granting lucrative golden parachutes to senior managers.
c. Establishing a super-majority provision in the companys bylaws which
raises the percentage of the board of directors that must approve an
acquisition from 50 percent to 75 percent.
d. All of the answers above are correct.
e. None of the answers above is correct.

Chapter 25 - Page 7

Miscellaneous concepts
37

Answer: c

Diff: E

Which of the following statements is most correct?

a. A conglomerate merger is where a firm combines with another firm in
the same industry.
b. Regulations in the United States prohibit acquiring firms from using
common stock to purchase another firm.
c. Defensive mergers are designed to make a company less vulnerable to a
takeover.
d. Answers a and b are correct.
e. All of the answers above are correct.

Medium:
Merger motivation
38

Answer: d

Diff: M

Which of the following statements is most correct?

a. Tax considerations often play a part in mergers. If one firm has
excess cash, purchasing another firm exposes the purchasing firm to
additional taxes. Thus, firms with excess cash rarely undertake
mergers.
b. The smaller the synergistic benefits of a particular merger, the
greater the incentive to bargain in negotiations, and the higher the
probability that the merger will be completed.
c. Since mergers are frequently financed by debt more than equity,
financial economies which imply a lower cost of debt or greater debt
capacity are rarely a relevant rationale for mergers.
d. Managers who purchase other firms often assert that the new combined
firm will enjoy benefits from diversification such as more stable
earnings.
However, since shareholders are free to diversify their
own holdings at lower cost, such a rationale is generally not a valid
motive for publicly held firms.
e. All of the answers above are correct.

Chapter 25 - Page 8

Level of merger activity

39

Answer: c

Diff: M

Which of the following statements is most correct?

a. The high value of the U.S. dollar relative to Japanese and European
currencies
in
the
1980s,
made
U.S.
companies
comparatively
inexpensive to foreign buyers, spurring many mergers.
b. During the 1980s, the Reagan and Bush administrations tried to foster
greater competition and they were adamant about preventing the loss
of competition; thus, most large mergers were disallowed.
c. The expansion of the junk bond market made debt more freely available
for large acquisitions and LBOs in the 1980s, and thus, it resulted
in an increased level of merger activity.
d. Increased nationalization of business and a desire to scale down and
focus on producing in one's home country virtually halted
international mergers in the 1980s.
e. Answers a and b are correct.

Merger analysis
40

Answer: e

Diff: M

Which of the following statements is most correct?

a. A firm acquiring another firm in a horizontal merger will not have
its required rate of return affected because the two firms will have
similar betas.
b. Financial theory says that the choice of how to pay for a merger is
really irrelevant because, although it may affect the firm's capital
structure, it will not affect the firm's overall required rate of
return.
c. The basic rationale for any financial merger is synergy and thus,
development of pro-forma cash flows is the single most important part
of the analysis.
d. In most mergers, the benefits of synergy and the price premium the
acquirer pays over market price are summed and then divided equally
between the shareholders of the acquiring and target firms.
e. The primary rationale for any operating merger is synergy, but it is
also possible that mergers can include aspects of both operating and
financial mergers.

Chapter 25 - Page 9

Aspects of mergers
41

Answer: d

Diff: M

Which of the following statements is most correct?

a. Firms that get acquired usually have a market price below book value
before the merger offer is made. However, once the initial offer is
made, the price can rise above book value, but the purchase price,
especially in large acquisitions, will remain within 20 percent of
book value.
b. When Texaco purchased Getty Oil, many financial analysts felt that
the deal made sense because it increased Texaco's market share and
expanded its shrinking oil reserves.
This merger exemplified the
belief among the natural resource companies that buying reserves
through acquisitions was less costly than exploring and finding them
in the field.
c. When Mobil Oil Company tried to acquire Conoco, another oil company,
stockholders were concerned that the U.S. Justice Department would
try to block this merger because it would lessen competition. Thus,
antitrust considerations affected this proposed horizontal merger.
d. Answers b and c are correct.
e. All of the statements above are false.

LBOs
42

Answer: e

Diff: M

Which of the following statements is most correct?

a. Leveraged buyouts (LBOs) are where a firm issues equity and uses the
proceeds to take a firm public.
b. In a typical LBO, bondholders do well but shareholders realize a
decline in value.
c. Firms are unable to sell any assets in the first five years following
a leverage buyout.
d. All of the answers above are correct.
e. None of the answers above is correct.

Miscellaneous concepts
43

Answer: b

Diff: M

Which of the following statements is most correct?

a. If a company which produces military equipment merges with a company
which manages a chain of motels, this is an example of a horizontal
merger.
b. A defensive merger is where the firm's managers merge with another
firm to avoid or lessen the possibility of being acquired through a
hostile takeover.
c. Acquiring firms send a signal that their stock is undervalued if they
choose to use stock to pay for the acquisition.
d. None of the statements above is correct.
e. Answers a and c are correct.

Chapter 25 - Page 10

Merger analysis
44

Answer: d

Diff: M

Which of the following statements about valuing a firm using the APV is
most correct?
a. The horizon value is calculated by discounting the horizon
free cash flows and tax savings at the levered cost of equity.
b. The horizon value is calculated by discounting the horizon
free cash flows at the levered cost of equity.
c. The horizon value is calculated by discounting the horizon
free cash flows and tax savings at the WACC.
d. The horizon value is calculated by discounting the horizons
free cash flows at the WACC.
e. None of the statements above is correct.

Merger analysis
45

Answer: c

future
future
future
future

Diff: M

Which of the following statements about valuing a firm using the APV is
most correct?
a. The value of operations is calculated by discounting the horizon
value, the tax shields, and the free cash flows at the cost of
equity.
b. The value of equity is calculated by discounting the horizon value,
the tax shields, and the free cash flows at the cost of equity.
c. The value of operations is calculated by discounting the horizon
value, the tax shields, and the free cash flows at the unlevered cost
of equity.
d. The value of equity is calculated by discounting the horizon value
and the free cash flows at the cost of equity.
e. None of the statements above is correct.

Merger accounting
46

Answer: b

Diff: M

Which of the following statements about accounting for mergers is most

correct?
a.
b.
c.
d.
e.

Goodwill is amortized for shareholder reporting.

Goodwill is amortized for Federal tax purposes.
Goodwill is no longer created in a merger.
Answers a and b are correct.
None of the statements above is correct.

Chapter 25 - Page 11

Multiple Choice: Problems

Easy:
Maximum price per share
47

$16.25
$16.97
$17.42
$18.13
$19.00

Intercompany dividends
.

Diff: E

American Hardware, a national hardware chain, is considering purchasing

a smaller chain, Eastern Hardware. American's analysts project that the
merger will result in incremental free flows and interest tax savings
with a combined present value of $72.52 million, and they have
determined that the appropriate discount rate for valuing Eastern is 16
percent. Eastern has 4 million shares outstanding. Eastern's current
price is $16.25.
What is the maximum price per share that American
should offer?
a.
b.
c.
d.
e.

48

Answer: d

Answer: a

Diff: E

A parent holding company sells shares in its subsidiary such that the
parent now owns only 65 percent of the subsidiary and thus, the tax
returns of the parent and its subsidiary can't be consolidated.
The
parent receives annual dividends from the subsidiary of $2,500,000. If
the parent's marginal tax rate is 34 percent and if the exclusion on
intercompany dividends is 70 percent, what is the effective tax rate on
the intercompany dividends and what are the net dividends received?
a.
b.
c.
d.
e.

10.2%;
10.2%;
23.8%;
10.2%;
34.0%;

$2,245,000
$2,135,000
$1,905,000
$1,750,000
$1,650,000

Chapter 25 - Page 12

Discount rate
49

Answer: c

Diff: E

Volunteer Pizza, a regional pizza chain, is considering purchasing a

smaller chain, Eastern Pizza, which is currently financed with 20
percent debt at a cost of 8%.
American's analysts project that the
merger will result in incremental free cash flows and interest tax
savings of $2 million in Year 1, $4 million in Year 2, $5 million in
Year 3, and $117 million in Year 4. (The Year 4 cash flow includes a
horizon value of $107 million.) The acquisition would be made
immediately, if it is undertaken. Eastern's pre-merger beta is estimated
to be 2.0, and its post-merger tax rate would be 34 percent. The riskfree rate is 8 percent, and the market risk premium is 4 percent. What
is the appropriate rate for discounting the free cash flows and the
interest tax savings?
a.
b.
c.
d.
e.

12.0%
13.9%
14.4%
16.0%
16.9%

Medium:
Post-merger return to equity
50

Answer: e

Diff: M

Trumble Oboes is considering a merger with Krieble Trombones. Kriebles

market determined beta is 0.9 and it is currently financed at a debt
level of 20%, at an interest rate of 8%. Krieble faces a 25% tax rate.
If Trumble acquires Krieble, it will increase the debt level to 60%, at
an interest rate of 9 percent, and the tax rate will increase to 35%.
The risk free rate is 6% and the market risk premium is 4%. What will
Kriebles required rate of return on equity be after it is acquired?
a.
b.
c.
d.
e.

7.4%
8.9%
9.3%
9.6%
9.7%

Chapter 25 - Page 13

Value of acquisition
51

$57.52
$61.96
$64.64
$76.96
$79.64

million
million
million
million
million

WACC for acquired firm

.

Diff: M

Pit Row Auto, a national autoparts chain, is considering purchasing a

smaller chain, Southern Auto.
Pit Row's analysts project that the
merger will result in incremental free cash flows and interest tax
savings of $2 million in Year 1, $4 million in Year 2, $5 million in
Year 3, and $117 million in Year 4.
The Year 4 cash flow includes a
horizon value of $107 million. Assume all cash flows occur at the end of
the year. Southern is currently financed with 30% debt at a rate of 10%.
The acquisition would be made immediately, if it is undertaken and
Southern would retain its current $15 million in debt and issue new debt
in order to continue targeting a 30% debt level. The interest rate will
remain the same. Southern's pre-merger beta is estimated to be 2.0, and
its post-merger tax rate would be 34 percent. The risk-free rate is 8
percent, and the market risk premium is 4 percent. What is the value of
Southern Autos equity to Pit Row Auto?
a.
b.
c.
d.
e.

52

Answer: b

Answer: d

Diff: M

Wildcat Systems currently has 1 million shares outstanding worth $10 per
share, and a capital structure that consists of 30% debt at a 9%
interest rate. Wildcat is considering purchasing Billybob Industries,
which has 500,000 shares outstanding worth $5 each and no debt.
Billybobs cost of equity is 12 percent and Wildcat Systems cost of
equity is 15%. If, after the purchase, Wildcat recapitalizes Billybob
to have the same capital structure as Wildcat, with debt at the same
interest rate, what will be Billybobs WACC? Both firms face a 40% tax
rate.
a.
b.
c.
d.
e.

10.0%
10.9%
12.0%
12.1%
15.0%

Chapter 25 - Page 14

Multiple part:
(The following information applies to the next four questions.)
Magiclean Corporation is considering an acquisition of Dustvac Company.
Dustvac has a capital structure consisting of $5 million (market value) in 11%
bonds and $10 million (market value) of common stock.
Dustvac's pre-merger
beta is 1.36. Magiclean's beta is 1.02 and both it and Dustvac face a 40
percent tax rate.
Magiclean's capital structure is 40 percent debt and 60
percent equity. The free cash flows and interest tax savings from Dustvac are
estimated to be $4.0 million for each of the next four years and a horizon
value of $15.0 million in Year 4. Additionally, new debt would be issued to
finance the acquisition and retire the old debt, and this new debt would have
an interest rate of 8%. Currently, the risk-free rate is 6.0 percent and the
market risk premium is 4.0 percent.
WACC of target
53

Answer: c

Diff: M

Answer: c

Diff: M

What Dustvacs pre-merger WACC?

a. 9.02%
b. 9.50%
c. 9.83%
d. 10.01%
e. 11.29%

Discount rate for value of operations

54

What discount rate should you use to discount the free cash flows and
interest tax savings?
a.
b.
c.
d.
e.

10.01%
10.06%
11.29%
11.44%
13.49%

Value of equity
55

Answer: b

Diff: M

What is the value of Dustvacs equity to Magiclean? (Round your answer

to the closest thousand dollars.)
a.
b.
c.
d.
e.

$17,019,000
$17,109,000
$17,916,000
$22,109,000
$22,916,000

Chapter 25 - Page 15

Tough:
Merger NPV
56

Answer: c

Diff: T

Blazer Breaks, Inc. is considering an acquisition of Laker Showtime

Company.
Blazer expects Lakers NOPAT to be of $9 million the first
year with all depreciation cash flows reinvested to replace equipment
and zero interest expense. For the second year, Laker is expected to
have NOPAT of $25 million and interest expense of $5 million. Also, in
the second year only, Laker will require net reinvestment of an
additional $10 million to finance future growth.
Laker's applicable
marginal tax rate is 40 percent. After the second year, the free cash
flows from Laker to Blazer will grow at a constant rate of 4 percent.
The firm has determined that Lakers cost of equity is 17.5 percent and
has estimated that after the second year the weighted average cost of
capital will be 14%. Laker currently has no debt outstanding. Assume
that all cash flows are end-of-year and that the Laker acquisition will
cost Blazer $45 million. Calculate the value to Blazer of Lakers equity
and determine the NPV of the proposed acquisition to Blazer.
a.
b.
c.
d.
e.

$ 45.0
$ 68.2
$ 88.0
$113.2
$133.0

million
million
million
million
million

Chapter 25 - Page 16

CHAPTER 25
ANSWERS AND SOLUTIONS

Chapter 25 - Page 17

1.

Synergistic merger

Answer: a

Diff: E

2.

Sources of synergy

Answer: a

Diff: E

3.

Spin-off

Answer: b

Diff: E

4.

Holding companies

Answer: b

Diff: E

5.

Defensive mergers

Answer: b

Diff: E

6.

Conglomerate merger

Answer: b

Diff: E

7.

Merger analysis

Answer: a

Diff: E

8.

Merger terms

Answer: a

Diff: E

9.

Defensive tactics

Answer: a

Diff: E

10.

Poison pill defense

Answer: a

Diff: E

11.

Joint venture

Answer: a

Diff: E

12.

Leveraged buyout

Answer: a

Diff: E

13.

Mergers and interest rates

Answer: b

Diff: E

14.

Merger accounting

Answer: b

Diff: E

15.

Merger accounting

Answer: b

Diff: E

16.

Merger accounting

Answer: a

Diff: E

17.

Holding company advantages

Answer: b

Diff: M

18.

International mergers

Answer: a

Diff: M

19.

Merger cash flows

Answer: b

Diff: M

20.

Relevant merger cash flows

Answer: a

Diff: M

21.

Financial merger

Answer: a

Diff: M

22.

Two-tier offer

Answer: b

Diff: M

23.

Vertical merger

Answer: a

Diff: M

24.

Congeneric merger

Answer: a

Diff: M

25.

Merger motivation

Answer: a

Diff: M

26.

Merger motivation

Answer: b

Diff: M

27.

Managerial control

Answer: b

Diff: M

28.

Managerial opposition

Answer: b

Diff: M

29.

Merger discount rate

Answer: b

Diff: M

30.

Synergistic gain

Answer: b

Diff: M

31.

Merger analysis

Answer: a

Diff: M

32.

Merger analysis

Answer: b

Diff: M

33.

Merger analysis

Answer: a

Diff: M

34.

Merger tactics

Answer: e

Diff: E

35.

Mergers

Answer: e

Diff: E

36.

Defensive strategies

Answer: d

Diff: E

37.

Miscellaneous concepts

Answer: c

Diff: E

38.

Merger motivation

Answer: d

Diff: M

39.

Level of merger activity

Answer: c

Diff: M

40.

Merger analysis

Answer: e

Diff: M

41.

Aspects of mergers

Answer: d

Diff: M

42.

LBOs

Answer: e

Diff: M

43.

Miscellaneous concepts

Answer: b

Diff: M

44.

Merger analysis

Answer: d

Diff: M

45.

Merger analysis

Answer: c

Diff: M

46.

Merger accounting

Answer: b

Diff: M

47.

Maximum price per share

Answer: d

Diff: E

Answer: a

Diff: E

Price per share =

$72.52 million
= $18.13.
$4 million

48

Intercompany dividends
Effective tax rate = (1 - Exclusion)(Tax rate)
= (1 - 0.70)(0.34) = 10.2%.

Net dividends = Gross dividends - Tax

= $2,500,000 - $2,500,000(1 - 0.70)(0.34)
= $2,500,000 - $255,000 = $2,245,000.
Alternate method
Effective tax rate = Tax amount/Gross dividends.
= 255,000/2,500,000 = 10.2%.

49
.

Discount rate

Answer: c

Diff: E

rsL = 8% + 2.0(4%) = 16%; rsU = 0.20(8%) + 0.80(16%) = 14.4%.

50
.

Post-merger return to equity

Answer: e

Diff: M

Calculate the current required return to Kriebles equity:

rK = rf + b(rmrp) = 6% + (0.9)4% = 9.6%
Calculate Kriebles unlevered cost of equity:
rU = wdrd + wsrs = 0.20(8%) + 0.80(9.6%) = 9.28%
Calculate Kriebles levered cost of equity at new capital structure with new
cost of debt:
rL = rU + (ru rd)(D/S) = 9.28% + (9.28% - 9%)/(0.6/0.4) = 9.7%
51
.

Value of acquisition

Answer: b

Diff: M

rL = rf + b(rmrp) = 8% + 2.0(4%) = 16%

rU = wdrd + wsrs = 0.30(10%) + 0.70(16%) = 14.2%
Time line: (In millions)
0 r = 14.2% 1
|
|
PV = ?
2

2
|
4

3
|
5

4 Years
|
10
HV = 107
FCF4 = 117

Financial calculator solution: (In millions)

Inputs: CF0 = 0; CF1 = 2; CF2 = 4; CF3 = 5; CF4 = 117; I = 14.2
Output: NPV = $76.96 = Value of operations.
Value of equity = value of operations value of debt = $76.96 15 = $61.96
million.
52

WACC for acquired firm

Answer: d

Diff: M

Billybobs unlevered cost of equity is 12%, because it has no debt.

At a
debt level of 30%, and a debt interest rate of 9% the levered cost of equity
is:
rsL = rsU + (rsU rd)(D/S) = 12% + (12% - 9%)(0.3/0.7) = 13.3%.
WACC = wdrd(1-T) + wSrS = 0.3(9%)(1 0.4) + 0.7(13.3%) = 10.9%
53
.

WACC of target
The pre merger weight on debt is 5/(5+10) = 0.333

Answer: c

Diff: M

The pre-merger required rate on equity is 6% + 1.36(4%) = 11.44%

WACC = wdrd(1-T) + wSrS = 0.333(11%)(1-0.40) + 0.667(11.44%) = 9.83%
54
.

Discount rate for value of operations

Answer: c

Diff: M

The correct discount rate is the unlevered cost of equity. The levered cost
of equity is 6% + 1.36(4%) = 11.44%, the percent of debt is 5/(5+10) = 0.333.
The rate on the debt is 11%
The unlevered cost of equity is w drd + wersL = 0.333(11%) + 0.667(11.44%) =
11.29%
55
.

Value of equity
Time line:

Answer: b

Diff: M

(In millions)

0 r=11.29% 1
|
|
PV = ?
4.0

2
|
4.0

3
|
4.0

4 Years
|
19.0

Financial calculator solution:

Inputs: CF0 = 0; CF1 = 4,000,000; Nj = 3; CF2 = 19,000,000; I = 11.29
Output: PVInflows = $22,109,662 = vops.
Value of equity = vops debt = 22.109 5 = $17.109 million.
56
.

Merger NPV
Time line:
0
|
-45

Answer: c
(In millions)
ru = 17.5% 1
|
+9

Diff: T

2
3 Years
g = 4%
|
|
+25
15(1.04)
-10
HV =
15(1.04)
15 = FCF
(0.14 0.04)
+ 2
= 156
17
156
173

Vops = 9/(1.175) + 173/(1.175)2 = $133.0 = V equity since there is no debt.

The npv is 133 45 = $88 million