Exam 7: Merger and Acquisition Cash Flow Valuation Basics

In the year in which it intends to go public, a firm has revenues of $20 million and net income after taxes of $2 million. The firm has no debt, and revenue is expected to grow at 20% annually for the next five years and 5% annually thereafter. Net profit margins are expected remain constant throughout. Capital expenditures are expected to grow in line with depreciation and working capital requirements are minimal. The average beta of a publicly traded company in this industry is 1.50 and the average debt/equity ratio is 20%. The firm is managed very conservatively and does not intend to borrow through the foreseeable future. The Treasury bond rate is 6% and the tax rate is 40%. The normal spread between the return on stocks and the risk free rate of return is believed to be 5.5%. Reflecting the slower growth rate in the sixth year and beyond, the firm's discount rate is expected to decline to the industry average cost of capital of 10.4%. Estimate the value of the firm's equity.

The estimation of present value using the constant growth model involves the calculation of a terminal value.

Interest payments are tax deductible to firms in the U.S.

Preferred dividends are tax deductible to U.S. corporations.

Viewing preferred dividends as paid in perpetuity, the cost of preferred stock can be calculated as dividends per share of preferred stock divided by the market value of the preferred stock.

Carlisle Enterprises, a specialty pharmaceutical manufacturer, has been losing market share for three years since several key patents have expired. The free cash flow to the firm in 2002 was $10 million. This figure is expected to decline rapidly as more competitive generic drugs enter the market. Projected cash flows for the next five years are $8.5 million, $7.0 million, $5 million, $2.0 million, and $.5 million. Cash flow after the fifth year is expected to be negligible. The firm's board has decided to sell the firm to a larger pharmaceutical company interested in using Carlisle's product offering to fill gaps in its own product offering until it can develop similar drugs. Carlisle's cost of capital is 15%. What purchase price must Carlisle obtain to earn its cost of capital?

For firms whose market value is less than $50 million, the adjustment to the CAPM in estimating the cost of equity can be as large as 2 percentage points.

Explain the conditions under which it makes most sense to use the zero growth and constant growth DCF models. Be specific.

Investors require a minimum rate of return on an investment to compensate them for the level of perceived risk associated with that investment.

Creating a Global Luxury Hotel Chain Fairmont Hotels & Resorts Inc. announced on January 30, 2006, that it had agreed to be acquired by Kingdom Hotels and Colony Capital in an all-cash transaction valued at $45 per share. The transaction is valued at $3.9 billion, including assumed debt. The purchase price represents a 28% premium over Fairmont's closing price on November 4, 2005, the last day of trading when Kingdom and Colony expressed interest in Fairmont. The combination of Fairmont and Kingdom will create a luxury global hotel chain with 120 hotels in 24 countries. Discounted cash-flow analyses, including estimated synergies and terminal value, value the firm at $43.10 per share. The net asset value of Fairmont's real estate is believed to be $46.70 per share. -Assume the acquirer divests all of Fairmont's hotels and real estate properties but continues to manage the hotels and properties under long-term management contracts. How would you estimate the net present value of the acquisition of Fairmont to the acquirer? Explain your answer.

In the absence of debt, $\beta$ measures the volatility of a firm's financial return to changes in the general market's overall financial return.

When evaluating an acquisition, you should do which of the following:

Do small changes in the assumptions pertaining to the estimation of the terminal value have a significant impact on the calculation of the total value of the target firm? If so, why?

When the firm increases its debt in direct proportion to the market value of its equity, the level of the debt is perfectly correlated with the firm's market value. Consequently, the risk associated with the tax shield (resulting from interest paid on outstanding debt) is the same as that associated with the firm.

The constant growth model is most applicable to firms in mature markets.

A firm's beta is affected by the amount of debt a firm maintains relative to its equity.

All of the following are true about the marginal tax rate for the firm except for

The cost of capital reflects all of the following except for

A beta coefficient is a measure of a firm's diversifiable risk.

The Hunt for Elusive Synergy—@Home Acquires Excite Background Information Prior to @Home Network's merger with Excite for $6.7 billion, Excite's market value was about $3.5 billion. The new company combined the search engine capabilities of one of the best-known brands (at that time) on the Internet, Excite, with @Home's agreements with 21 cable companies worldwide. @Home gains access to the nearly 17 million households that are regular users of Excite. At the time, this transaction constituted the largest merger of Internet companies ever. At the time of the transaction, the combined firms, called Excite @Home, displayed a P/E ratio in excess of 260 based on the consensus earnings estimate of $0.21 per share. The firm's market value was $18.8 billion, 270 times sales. Investors had great expectations for the future performance of the combined firms, despite their lackluster profit performance since their inception. @Home provided interactive services to home and business users over its proprietary network, telephone company circuits, and through the cable companies' infrastructure. Subscribers paid $39.95 per month for the service. Assumptions • Excite is properly valued immediately prior to announcement of the transaction. • Annual customer service costs equal $50 per customer. • Annual customer revenue in the form of @Home access charges and ancillary services equals $500 per customer. This assumes that declining access charges in this highly competitive environment will be offset by increases in revenue from the sale of ancillary services. • None of the current Excite user households are current @Home customers. • New @Home customers acquired through Excite remain @Home customers in perpetuity. • @Home converts immediately 2 percent or 340,000 of the current 17 million Excite user households. • @Home's cost of capital is 20 percent during the growth period and drops to 10 percent during the slower, sustainable growth period; its combined federal and state tax rate is 40 percent. • Capital spending equals depreciation; current assets equal current liabilities. • FCFF from synergy increases by 15 percent annually for the next 10 years and 5 percent thereafter. Its cost of capital after the high-growth period drops to 10 percent. • The maximum purchase price @Home should pay for Excite equals Excite's current market price plus the synergy that results from the merger of the two businesses. - What are the limitations of the discounted cash flow method employed in this case?