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Aubey Appliance Corporation is considering a merger with theVelmore Vacuum Company. Velmore is a publicly traded company, and its current betais 1.30. Velmore has been barely profitable, so it has paid an average of only 20% intaxes during the last several years. In addition, it uses little debt, having a debt ratio ofjust 25%.If the acquisition were made, Aubey would operate Velmore as a separate, whollyowned subsidiary. Aubey would pay taxes on a consolidated basis, and the tax rate wouldtherefore increase to 35%. Aubey also would increase the debt capitalization in the Velmoresubsidiary to 40% of assets, which would increase its beta to 1.47. Aubey’s acquisition department estimates that Velmore, if acquired, would produce the following cash flows toAubey’s shareholders (in millions of dollars):Year                       Cash Flows1                               $1.252                              1.453                               1.654                              1.855 and beyond           Constant growth at 6%These cash flows include all acquisition effects. Aubey’s cost of equity is 14%, its beta is 1.0,and its cost of debt is 10%. The risk-free rate is 9%.a. What discount rate should be used to discount the estimated cash flows? (Hint: UseAubey’s rs to determine the market risk premium.)b. What is the dollar value of Velmore to Aubey?c. Velmore has 1.5 million common shares outstanding. What is the maximum price pershare that Aubey should offer for Velmore? If the tender offer is accepted at this price,what will happen to Aubey’s stock price?

Question

Aubey Appliance Corporation is considering a merger with the
Velmore Vacuum Company. Velmore is a publicly traded company, and its current beta
is 1.30. Velmore has been barely profitable, so it has paid an average of only 20% in
taxes during the last several years. In addition, it uses little debt, having a debt ratio of
just 25%.
If the acquisition were made, Aubey would operate Velmore as a separate, wholly
owned subsidiary. Aubey would pay taxes on a consolidated basis, and the tax rate would
therefore increase to 35%. Aubey also would increase the debt capitalization in the Velmore
subsidiary to 40% of assets, which would increase its beta to 1.47. Aubey’s acquisition department estimates that Velmore, if acquired, would produce the following cash flows to
Aubey’s shareholders (in millions of dollars):
Year                       Cash Flows
1                               $1.25
2                              1.45
3                               1.65
4                              1.85
5 and beyond           Constant growth at 6%
These cash flows include all acquisition effects. Aubey’s cost of equity is 14%, its beta is 1.0,
and its cost of debt is 10%. The risk-free rate is 9%.
a. What discount rate should be used to discount the estimated cash flows? (Hint: Use
Aubey’s rs to determine the market risk premium.)
b. What is the dollar value of Velmore to Aubey?
c. Velmore has 1.5 million common shares outstanding. What is the maximum price per
share that Aubey should offer for Velmore? If the tender offer is accepted at this price,
what will happen to Aubey’s stock price?

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