Question

1 question (60%) Prime Corporation is viewed as a possible takeover tar- get by TVC Enterprises, Inc. Currently, Prime uses 25 percent debt in its capital structure, but TVC plans to increase the debt ratio to 40 percent if the acquisition is consummated. Prime's after-tax cost of debt is 10 percent, which should hold constant. The cost of equity after the acquisition is expected to be 20 percent. The current market value of Primes debt outstanding is $30 million, all of which will be assumed by TVC. TVC intends to pay $150 million in cash and common stock for all of Prime's stock in addition to assuming all of its debt. Currently, the market price of Prime's common stock is $125 million. Selected items from Prime's financial data are as follows 2004 2005 2006 2007 THEREAFTER MILLIONS Net sales Administrative and selling expenses Depreciatiorn Capital expenditures $300 $335 S370 $400 40 25 30 50 30 37 $425 65 40 50 35 45 38 48 In addision, the cont of goods sold runs 60 percent of sales, and the marginal tax rate is 34 per- cent. Compute the NPV of the acquisition. Required: Compute NPV of the acqguisition a. b. Make decision to acquire or not. Explain

Answer 1

In the above question we are assuming that the takeover will take place after 2007. Thus the NPV calculation was done for inflows as Perpetual Annuity and for outflows the discount factor was 1 only. We know that the total outflow for takeover will be $150 million (Cash and Common Stock) and $30 million (Debt outstanding). Thus total outflow of $180 million will be multiplied by discount factor of 1.

For inflows we have taken from the problem Net Sales: $425 mn; less COGS (60% of sales): $255 mn; less ASE: $65 mn; less Interest: $3mn; less Depreciation: $40mn; PBT will come as $62 mn from which 34% tax will be deducted i.e. $21.08mn resulting in PAT $40.92mn. We will add back depreciation which is a non cash item thus the Cash inflow will be $80.92 mn. The question also highlight a capex of $50 mn after 2007 every year which is an outflow thus net Cash Inflow for perpetual annuity purpose will be $30.92 mn. The cost of capital is calculated using weighted cost formula which is resulting in 16% as after takeover 40% will be debt @10% cost and 60% equity @ 20% cost. The formula for perpetual cash inflow present value will result in $30.92/0.16 resulting to $193.25mn. Thus the NPV will be positive $13.25mn.

(b) As NPV is positive the acquisation should be done.