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Fundamentals of Financial Manageme...

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Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

MERGER ANALYSIS Smitty’s Home Repair Company, a regional hardware chain that specializes in do-it-yourself materials and equipment rentals, is cash rich because of several consecutive good years. One of the alternative uses for the excess funds is an acquisition. Linda Wade, Smitty’s treasurer and your boss, has been asked to place a value on a potential target, Hill’s Hardware, a small chain that operates in an adjacent state, and she has enlisted your help.

Table IC 21.1 indicates Wade’s estimates of Hill’s earnings potential if it comes under Smitty’s management (in millions of dollars). The interest expense listed here includes the interest (1) on Hill’s existing debt, (2) on new debt that Smitty’s would issue to help finance the acquisition, and (3) on new debt expected to be issued over time to help finance expansion within the new “H division,” the code name given to the target firm. The retentions represent earnings that will be reinvested within the H division to help finance its growth.

Hill’s Hardware currently uses 40% debt financing, and it pays federal-plus-state taxes at a 30% rate. Security analysts estimate Hill’s beta to be 1.2. If the acquisition were to take place, Smitty’s would increase Hill’s debt ratio to 50%, which would increase Hill’s beta to 1.3. Further, because Smitty’s is highly profitable, taxes on the consolidated firm would be 40%. Wade realizes that Hill’s Hardware also generates depreciation cash flows, but she believes that these funds would have to be reinvested within the division to replace worn-out equipment.

Wade estimates the risk-free rate to be 9% and the market risk premium to be 4%. She also estimates that cash flows after 2021 will grow at a constant rate of 6%. Smitty’s management is new to the merger game, so Wade has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Wade has developed the following questions, which you must answer and then defend to Smitty’s board.

  1. a. Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax considerations, (2) risk reduction. (3) control, (4) purchase of assets at below-replacement cost, and (5) synergy. In general, which of the reasons are economically justifiable? Which are not? Which fit the situation at hand? Explain.
  2. b. Briefly describe the differences between a hostile merger and a friendly merger.
  3. c. Use the data developed in Table IC 21.1 to construct the H division’s cash flow statements for 2018 through 2021. Why is interest expense deducted in merger cash flow statements, whereas it is not normally deducted in a capital budgeting cash flow analysis? Why are earnings retentions deducted in the cash flow statement?
  4. d. Conceptually, what is the appropriate discount rate to apply to the cash flows developed in part c? What is your actual estimate of this discount rate?
  5. e. What is the estimated continuing value of the acquisition; that is, what is the estimated value of the H division’s cash flows beyond 2021? What is Hill’s value to Smitty’s? Suppose another firm were evaluating Hill’s as an acquisition candidate. Would it obtain the same value? Explain.
  6. f. Assume that Hill’s has 10 million shares outstanding. These shares are traded relatively infrequently, but the last trade, made several weeks ago, was at a price of $9 per share. Should Smitty’s make an offer for Hill’s? If so, how much should it offer per share?
  7. g. What merger-related activities are undertaken by investment bankers?

a.

Summary Introduction

To Determine: The reasons that is economically justifiable among tax considerations, control, synergy, risk reduction and buying of assets at a below-replacement cost.

Introduction: A merger is the mix of two organizations into one by either shutting the old entities into one new entity or by one organization engrossing the other. In other terms, at least two organizations are united into one organization to form a merger.

Explanation

The reasons that are economically justifiable among tax considerations, control, synergy, risk reduction and buying of assets at below-replacement cost is as follows:

The rationale that is economically justifiable for mergers are synergy and tax consequences. Synergy happens when the estimation of the joined firm surpasses the total of the estimations of the organizations taken independently. A synergistic merger makes value that must be allotted between the stockholders of the merging organizations.

Synergy can emerge from the below four sources:

  • Through expanded market control because of decreased rivalry. The operating and money related economies are socially appropriate, as mergers that increase the administrative effectiveness, but mergers that decrease rivalry are both unattractive and unlawful.
  • Through financial economies, this might incorporate higher debt limit, decreasing transaction expenses, or better inclusion by securities’ examiners that can prompt greater demand and thus greater costs.
  • Through operating economies of scale in administration, creation, marketing or conveyance.
  • Through differential management effectiveness, which suggests that new administration can expand the value of a firm's assets.

Another legitimate justification behind mergers is tax consideration. For instance, a firm that is extremely cost-effective and thusly in the most noteworthy corporate-tax section could procure an organization with huge accumulated tax losses, and promptly utilize those losses to protect its present and future revenue. Without the merger, the carry forwards may inevitably be utilized, yet their value would be greater whenever utilized now as opposed to the future...

b.

Summary Introduction

To Determine: The similarities between hostile merger and friendly merger.

c.

Summary Introduction

To Determine: The cash flow statement of Division HH’s from 2018 to 2021, the reasons on why the interest expense deducted in merger cash flow statement and the reasons on why earnings retentions deducted in cash flow statement.

d.

Summary Introduction

To Determine: The appropriate discount rate to apply to the cash flows developed in the previous part and the actual estimate of the discount rate.

e.

Summary Introduction

To Determine: The estimated continuing value of acquisition and the value of Company HH to Company SHR and whether it would be the same value if another firm evaluating Company HH as acquisition.

f.

Summary Introduction

To Determine: Whether Company SHR makes an offer for Company H, if offered the share price.

g.

Summary Introduction

To Determine: The merger related activities that are undertaken by investment bankers.

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Fundamentals of Financial Management, Concise Edition (with Thomson ONE - Business School Edition, 1 term (6 months) Printed Access Card) (MindTap Course List)