Exam 26: Mergers, Lbos, Divestitures, and Holding Companies

Kelly Tubes is considering a merger with Reilly Tires. Reilly's market-determined beta is 0.9, and the firm currently is financed with 20% debt, at an interest rate of 8%, and its tax rate is 25%. If Kelly acquires Reilly, it will increase the debt to 60% , at an interest rate of 9%, and the tax rate will increase to 35%. The risk-free rate is 6% and the market risk premium is 4%. What will Reilly's required rate of return on equity be after it is acquired?

Leveraged buyouts (LBOs) occur when a firm's managers, generally backed by private equity groups, try to gain control of a publicly owned company by buying out the public shareholders using large amounts of borrowed money.

Which of the following statements about accounting for mergers is most CORRECT?

Magiclean Corporation is considering the acquisition of Dustvac Company. Dustvac has a capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock. Dustvac's pre-merger beta is 1.36. Magiclean's beta is 1.02 , and both it and Dustvac face a 40% tax rate. Magiclean's capital structure is 40% debt and 60% equity. The free cash flows from Dustvac are estimated to be $3.0 million for each of the next 4 years and a horizon value of $10.0 million in Year 4. Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4. New debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%. -What discount rate should you use to discount Dustvac's free cash flows and interest tax savings?

A conglomerate merger occurs when two firms with either a horizontal or a vertical business relationship combine.

Which of the following actions can help managers defend against a hostile takeover?

Discounted cash flow methods are not appropriate for evaluating mergers because the cash flows are uncertain and the discount rate can only be determined after the merger is consummated.

Most defensive mergers occur as a result of managers' actions to maximize shareholders' wealth.

Which of the following statements is most CORRECT?

Which of the following are given by the text as valid, acceptable reasons for the high level of merger activity in the U.S. during the 1980s?

A parent holding company sells shares in its subsidiary such that the parent now owns only 65% of the subsidiary and, thus, the tax returns of the parent and its subsidiary can't be consolidated. The parent receives annual dividends from the subsidiary of $2,500,000 . If the parent's marginal tax rate is 34% and if the exclusion on intercompany dividends is 70%, what is the effective tax rate on the intercompany dividends, and how much net dividends are received?

Since managers' central goal is to maximize stock price, managerial control issues do not interfere with mergers that would benefit the target firm's stockholders.

The distribution of synergistic gains between the stockholders of 2 merged firms is almost always based strictly on their respective market values before the announcement of the merger.

Magiclean Corporation is considering the acquisition of Dustvac Company. Dustvac has a capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock. Dustvac's pre-merger beta is 1.36. Magiclean's beta is 1.02 , and both it and Dustvac face a 40% tax rate. Magiclean's capital structure is 40% debt and 60% equity. The free cash flows from Dustvac are estimated to be $3.0 million for each of the next 4 years and a horizon value of $10.0 million in Year 4. Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4. New debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%. -What Dustvac's pre-merger WACC?

If a petrochemical firm that used oil as feedstock merged with an oil producer that had large oil reserves and a drilling subsidiary, this would be a vertical merger.

Which of the following statements is most CORRECT?

Which of the following statements is most CORRECT?

The 3 main advantages of holding companies are (1) control with fractional ownership, (2) taxation benefits, and (3) isolation of operating risks.

The purchase of assets at below their replacement cost and tax considerations are two factors that motivate mergers.

The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if it had no debt.