Question

Stubborn Motors, Inc. is asking a price of $93 million to be purchased by Rubber Tire Motor Corp. Stubborn Motors currently has total cash flows of $2 million that are expected to grow indefinitely by 1 percent annually. Managers estimate that, because of synergies, the merged firm's cash flows will increase by $5 million in the first year after the merger and that these cash flows will grow by an additional 5 percent in years 2 through 4 following the merger. After the first four years, these incremental cash flows will grow at a rate of 1 percent annually. The WACC for the merged firms is 10 percent. Calculate the NPV of the merger. (Enter your answer in millions. Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your final answer to 2 decimal places.) NPV million Should Rubber Tire Motor Corporation agree to acquire Stubborn Motors for the asking price of $93 million? O yes O no

Answer 1

NPV of the merger = present value of cash flows after merger - asking price

present value of cash flows after merger = Year 1 cash flow/(1+WACC) + Year 2 cash flow/(1+WACC)² + Year 3 cash flow/(1+WACC)³ + (Year 4 cash flow + terminal cash flow)/(1+WACC)⁴

terminal cash flow is the cash flows for years 5 and beyond. it is calculated at the end of Year 4. so, it will be discounted for 4 years only.

terminal cash flow = [Year 4 Cash flows after merger*(1+indefinite growth rate)]/(WACC - indefinite growth rate)

Years	0	1	2	3	4	5
Asking price	-$93	$0	$0	$0	$0	$0
Cash flows before merger	$0	$2.00	$2.02	$2.04	$2.06	$2.08
Synergies	$0	$5.00	$5.25	$5.51	$5.79	$5.85
Cash flows after merger	$0	$7.00	$7.27	$7.55	$7.85	$7.93
Terminal cash flows	$0	$0	$0	$0	$88.08	$0
Total cash flows	-$93	$7.00	$7.27	$7.55	$95.93	$0
NPV	-$9.43

Calculations

A с D G 1 0 2 3 4 -93 o 0 0 2 Years 3 Asking price 4 Cash flows before merger 5 Synergies 6 Cash flows after merger 7 Terminal cash flows 8 Total cash flows 9 NPV 0 0 0 =C4*1.01 =C5*1.05 =D4+D5 0 =D4*1.01 =D5*1.05 =E4+E5 5 o =F4*1.01 =F5*1.01 =G4+G5 lo =E4*1.01 =E5*1.05 =F4+F5 =G6/(10%-1%) =F6+F7 5 =C4+C5 0 =C6+C7 0 0 0 =D6+D7 =E6+E7 0 =B3 =NPV(10%,C8:F8)+B8

No, Rubber Tire Motor Corporation should not agree to acquire Stubborn Motors for asking price of $93 million because NPV of the merger is -$9.43 million which is negative and a loss.