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MERGER ANALYSIS 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 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?

BuyFind

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781337395250
BuyFind

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781337395250

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Chapter
Section
Chapter 21, Problem 4P
Textbook Problem

MERGER ANALYSIS 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%.

  1. a. What discount rate should be used to discount the estimated cash flows? (Hint: Use Aubey’s to determine the market risk premium.)
  2. b. What Is the dollar value of Velmore to Aubey?
  3. 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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