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5. Merger analys is Adjusted present value (APV) approach Aa Aa BTR Warehousing, which is considering the acquisition of Dual Purposes Products Co. (DPP), estimates that acquiring DPP will result in an incremental value for the firm. The analysts involved in the deal have collected the following information from the projected financial statements of the target company: Data Collected (in millions of dollars) Year 1 Year 2 Year 3 EBIT $13.0 $15.6 $19.5 Interest expense 3.0 3.3 3.6 Debt 33.0 39.0 42.0 Total net operating capital 105.1 107.1 109.1 Dual Purposes Products Co. (DPP) is a publicly traded company, and its market-determined pre-merger beta is 1.60 You also have the following information about the company and the projected statements: DPP currently has a $16.00 million market value of equity and $10.40 million in debt. The risk-free rate is 4%, there is a 6.10% market risk premium, and the Capital Asset Pricing Model produces a pre-merger required rate of return on equity rsL of 13.76% DPP's cost of debt is 6.00% at a tax rate of 40% The projections assume that the company will have a post-horizon growth rate of 5.00% Current total net operating capital is $102.0, and the sum of existing debt and debt required to maintain a constant capital structure at the time of acquisition is $30 million. The firm does not have any nonoperating assets such as marketable securities Given this information, use the adjusted present value (APV) approach to calculate the following values involved in merger analysis: Value Unlevered cost of equity 7,78% Horizon value of unlevered cash flows Horizon value of tax shield Unlevered value of operations Value of tax shield Value of operations Thus, the total value of DPP's equity is 7.78% 7.78% 11.98% 9.06% 10.70% $178.68 million $170.18 million $135.58 million $82.46 million $26.53 million $24.32 million $25.26 million $42.11 million $62.02 million $149.12 million $143.11 million $147.87 million $22.78 million $26.70 million $61.70 million $62.16 million $210.03 million $169.81 million $171.90 million $123.72 million $51.62 million $138.72 million 199.63 million $161.50 million Suppose BTR Warehousing plans to use more debt in the first few years of the acquisition of Dual Purposes Products Co. (DPP) Assuming that using more debt will not lead to an increase in bankruptcy costs for BTR Warehousing, the interest tax shields and the value of the tax shield in the analysis, will of operations of the acquired firm. , leading to a value The APV approach is considered useful for valuing acquisition targets, because the method involves finding the values of the unlevered firm and the interest tax shield separately and then summing those values. Why is it difficult to value certain types of acquisitions using the corporate valuation model? The acquiring firm usually assumes the debt of the target firm. Thus, old debt with different coupon rates usually becomes a part of the acquisition deal. The acquiring firm immediately retires the target firm's old debt. Thus, the acquisition deal consists of only new debt in its capital structure.

Answer 1

Calculation of cost of unlevered equity:
TV = Equity value + Debt value	Total value	26.40
Equity value/TV	Weight of equity (ws)	0.61
Debt value/TV	Weight of debt (wd)	0.39
Using CAPM	Cost of levered equity (rsL)	13.76%
	Cost of debt (rd)	6.00%
(ws*rsL) + (wd*rd)	Cost of unlevered equity (rsU)	10.70%

Value of unlevered operations:
Formula	Year (n)	0	1	2	3	Perpetuity
	Growth rate g					5%
	EBIT		13.00	15.60	19.50
EBIT*Tax	Tax @ 40%		5.20	6.24	7.80
EBIT - Tax	After-tax EBIT (AT EBIT)		7.80	9.36	11.70
	Total net operating capital (NOC)	102.00	105.10	107.10	109.10
NOCn - NOCn-1	Less: Change in net operating capital		3.10	2.00	2.00
AT EBIT - Change in net op. capital	Free Cash Flow (FCF)		4.70	7.36	9.70	10.19
FCF4/(rsU -g)	Horizon value (HV)					178.59
	Total FCF (TFCF)		4.70	7.36	9.70	178.59
1/(1+rsU)^n	Discount factor @ rsU		0.903	0.816	0.737	0.737
(Total FCF*Discount factor)	PV of FCF		4.25	6.01	7.15	131.64
Sum of all PVs	Total PV	149.04
Value of tax shield:
Formula	Year (n)	0	1	2	3	Perpetuity
	Growth rate (g)					5%
(I5 = I4*(1+g)	Interest		3.00	3.30	3.60	3.78
	Tax @ 40%		40%	40%	40%	40%
(Interest*Tax)	Tax shield (TS)		1.20	1.32	1.44	1.51
TS5/(rsU-g)	Horizon value					26.51
	Total TS		1.20	1.32	1.44	26.51
1/(1+rsU)^n	Discount factor @ rsU		0.903	0.816	0.737	0.737
(Total TS*Discount factor)	PV of TS		1.08	1.08	1.06	19.54
Sum of all PVs	Total PV	22.76

			Answers
rsU	Unlevered cost of equity	10.70%	10.70%
HV FCF	Horizon value of unlevered cash flows	178.59	178.68
HV TS	Horizon value of tax shield	26.51	26.53
PVunlevered	Unlevered value of operations	149.04	149.12
PVtaxshield	Value of tax shield	22.76	22.78
V = PVunlevered + PVtaxshield	Value of operations	171.80	171.90
D	Less: debt	10.40	10.40
V-D	Equity value	161.40	161.50

Note: There are slight differences between the answers given in the MCQs and the calculated answers which can be due to rounding off,as values provided are in millions and not complete numbers. Please use the numbers given in the answers column.

Assuming that using more debt will not lead to an increase in bankruptcy costs, the interest tax shields and value of the tax shield will increase, leading to a higher value of operations of the acquired firm.

Statement 1 is correct - The acquiring firm usually acquires the debt of the target firm. Thus, old debt with different coupon rates usually becomes a part of the acquisition deal. Additionally, the acquisition may be financed by new debt which is paid off quickly so that the capital structure during the 1st few years after the acquisition is not constant. This makes APV model ideal for merger situations.