Question

Freeca-fro vaaion) The Brown Corporationis viewed as a possble takeover burget y Cicron, Inc. Currentdy, Brown uses 20 percent debt in is cupital structure, but Cicron plans o increase the debt ratio to 25 percent if the scquistion is consummated The fer-tar cost of debt capital for Brown is estimated to be 8 percent, which holds constant under either apital structure. The cost of equty after th acquisition is eapected to be 22 percent. The current mar ket value of Brown's oustanding debt is $75 million, ll f which vwill be assumed by Clcron Cicron intends to pay $225 milion incash and common stock for l of Browns stock in addition to assuming all of Brown' debt. Currently, the market price of Browns common stock is $200 million. Selected items from Brown's financial data are as follows 2004 2005 2008 2007 THEREAFTER (MILLIONS) Net sales dministrative andslling expenses 2525 25 30 30 Depreciation Capital expenditures $280 $265 $280 $290 $300 15 17 18 23 30 22 18 18 20 22 Inadion, the cost of goods sold runs 50percent of sales and the marginal tar rate is Apercent. 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

First, we need to find the
WACC to discount Free cash flows of Brown
by using the formula:
WACC=(Wt.Debt*After-tax Cost Debt)+(Wt. equity*Cost Equity)
ie.(25%*8%)+(75%*22%)=
18.5%
	2004	2005	2006	2007	Thereafter
Year	1	2	3	4
1.Net sales	260	265	280	290	300
2.COGS(Sales*50%)	-130	-132.5	-140	-145	-150
3. Admn. &Sell. Exp.	-25	-25	-25	-30	-30
4.Depreciation	-15	-17	-18	-23	-30
5.EBT(1+2+3+4)	90	90.5	97	92	90
6.Tax at 34%(Row 5*34%)	-30.6	-30.77	-32.98	-31.28	-30.6
7.EAT(5+6)	59.4	59.73	64.02	60.72	59.4
8. Add back: depn.	15	17	18	23	30
9. Opg. Cash flow	74.4	76.73	82.02	83.72	89.4
10. CAPEX	-22	-18	-18	-20	-22
11.FCFF(9+10)	52.4	58.73	64.02	63.72	67.4
12. Terminal FCFF(67.4/18.5%)				364.3243
13. Total FCFF(11+12)	52.4	58.73	64.02	428.0443
14. PV F at 18.5%(1/1.185^n)	0.843882	0.712137	0.600959	0.507139
15. PV at 18.5%	44.21941	41.82378	38.4734	217.0778
16. NPV (sum of row 15)	341.5944
17.Current market value of Brown's Debt	75
18. Brown's FCFE(16-17)	266.5944
	Millions
a. NPV of acquisition=Value of Brown Corporation's FCFs=341.5944 millions
b. Current market value of Brown's common stock is 200 millions,ie. less than the actual or true value $ 266 millions ,calculated as above, discounting its FCFs--which indicates under-valuation of its stock by the market forces indicating less demand by investors.
Hence NOT RECOMMENDED to buy.