Question

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Pre re oswer uget eecab y Clicron, Inc. CurreadyBrown uses 20 percent debt in is capital structure, but Cicron plans to increae the debt ratio to 25 percent if the scquistion is consummated The after-tar cost of debt capital for Brown is estimated to be 8percent, which holds constant under either apital structure. The cost of equity sfer the acquisition is expected to be 22 percent. The curent ket value of Brown' oustanding debt is S75 million, ll f which will be assumed by Clcron. Cicron intends to pay S225 million in cash and common stock for all f Brown's stock in sddition to suming al of Browas debt. Currendy the murket price of Browa's common stock is $200 millio. Selected items from Brown's financial data are as follows 2004 2005 2006 2007 THEREAFTER (MILLIONS) $260 $265 $280 $290 $300 Net sales dministrative and selling expenses 25 25 25 30 3 Depreciation Capital expendlitures 15 17 18 2330 22 8 18 20 22 Insddition, the cost of goods sold runs 50percent of sales andthe marginal tax rate is 34 percent. Compute the net present value of the acquisition Required: a. Compute NPV of the acquisition b. Make decision to acquire or not Explain

Answer 1

WACC for Brown if the acquisition goes through:

WACC = (weight(debt) * Cost(debt) * (1 - tax rate)) + (weight(equity) * cost(equity))

weight(debt) after acquisition = 25%

cost(debt) = 8%

tax rate = 34%

weight(equity) = 1 - weight(debt) = 1 - 0.25 = 0.75 = 75%

cost(equity) after acquisition = 22%

WACC = (0.25 * 0.08 * (1 - 0.34)) + (0.75 * 0.22)

= (0.25 * 0.08 * 0.66) + (0.75 * 0.22)

= 0.0132 + 0.165 = 0.1782

WACC = 17.82%

For computing PV of Brown:

(All values are in $ million, unless states otherwise)

Particulars	2004	2005	2006	2007	Thereafter	Formula
Net Sales	260	265	280	290	300
(-) Cost of goods sold (COGS)	(130)	(132.5)	(140)	(145)	(150)	50% of net sales
Gross profit (GP)	130	132.5	140	145	150	Net sales - COGS
(-) Administrative & Selling Expenses	(25)	(25)	(25)	(30)	(30)	Given in question
(-) Depreciation (Dep)	(15)	(17)	(18)	(23)	(30)	Given in question
Earnings before Interest & taxes (EBIT)	90	90.5	97	92	90	GP - Admin - Dep
(-) Taxes at 34%	(30.6)	(30.77)	(32.98)	(31.28)	(30.6)
Net Income	59.4	59.73	64.02	60.72	59.4	EBIT - taxes
(+) Depreciation	15	17	18	23	30
Net Operating Profit after tax (NOPAT)	74.4	76.73	82.02	83.72	89.4	Net Income + Dep
(-) Capital Expenditure (Capex)	(22)	(18)	(18)	(20)	(22)	Given in question
Free cash flow to the firm (FCFF)	52.4	58.73	64.02	63.72	67.4	NOPAT - Capex
Discounting factor at WACC of 17.82%	1/(1 +0.17821) = 0.8488	1/(1 +0.17822) = 0.7204	1/(1 +0.17823) = 0.6114	1/(1 +0.17824) = 0.5189	1/(1 +0.17825) = 0.4405
PV of FCFF	44.48	42.31	39.14	33.06	29.69	FCFF * Discounting factor

Sum of PV of FCFF = 44.48 + 42.31 + 39.14 + 33.06 + 29.69

= 188.68

NPV acquisition = PV of FCFF - PV of cash outflow by Cicron

= 188.68 - 225

= -36.32

Implying that the present values of potential future inflows from brown are values at $188.68 million which is lower than the market value of the common stock of brown at $200 million as well as amount of $225 million which Cicron is expected to pay for the acquisition. in this scenario, the overall acquisition will lead to net cash outflow for Cicron and hence, Cicron should not acquire Brown.