Question

A sporting goods manufacturer has decided to expand into a related business. Management estimates that to build and staff a facility of the desired size and to attain capacity operations would cost $960 million in present value terms. Alternatively, the company could acquire an existing firm or division with the desired capacity. One such opportunity is a division of another company. The book value of the division’s assets is $850 million and its earnings before interest and tax are presently $110 million. Publicly traded comparable companies are selling in a narrow range around 12 times current earnings. These companies have book value debt-to-asset ratios averaging 40 percent with an average interest rate of 10 percent.

a. Using a tax rate of 35 percent, estimate the minimum price the owner of the division should consider for its sale. (Do not round intermediate calculations. Enter your answer in millions rounded to 1 decimal place.)

What is the minimum price (in millions)

Answer 1

Answer:$760 million

First, Calculate the current earnings after interest and tax.

Debt to asset ratio=40%

Assets=$850 million

So. Debt=40%*assets=40%*850m=$340m

Interest rate=10%

So, interest =10%*debt=$34m

Given EBIT=$110 million

EBT=EBIT-INTEREST

EBIT=$110 m-$34

=$76m

Tax rate=35%

So,

Earnings=EBT*(100%-tax rate)

=$76*(100%-35%)

=$76*65%

=$49.4 million

1.Current earnings multiple

Using industry average valuation of 12x earnings, the division value is

Value=12x$49.4

=$592.8 million

2. Equivalent earning capacity

The amount of capital required to generate after tax earnings of $49.4 million would be

Required capital=$49.4 m/(100%-tax rate,)/market interest rate

=[$49.4 m/(100%-35%)/10%]

=[$49.4 m/65%/10%]

   = [$76m/10%]

=$760 million

The minimum price required for the owner of the division is $760 million