Chapter 7: A Primer on Merger and Acquisition Valuation

Answers to End of Chapter Discussion Questions

7-1. What is the significance of the weighted average cost of capital? How is it calculated? Do the weights reflect the firm’s actual or
target debt to total capital ratio? Why?

Answer: The weighted average cost of capital (WACC) is a broader measure than the cost of equity and represents the return
a firm must earn in order to induce investors to buy its stock and bonds. The WACC is calculated using a weighted average
of the firm’s cost of equity and cost of debt. The weights associated with the cost of equity and debt, reflect the firm’s target
capital structure or capitalization. These are targets in the sense that they represent the capital structure the firm hopes to
achieve and sustain in the future. It is important to remember that these are targets and not the current actual values. The actual
market value of equity and debt as a percent of total capitalization may differ from the targets. Market values rather than book
values are used, because WACC measures the cost of issuing debt and equity securities at current market prices. Such securities
are issued at market and not book value.

7-2. What does a firm’s ß measure? What is the difference between an unlevered and levered ß? Why is this distinction significant?

Answer: A beta coefficient (β) is a measure of nondiversifiable risk or the extent to which a firm’s (or asset’s) return changes

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due to a change in the market’s return. It is a measure of the risk of a stock’s financial returns, as compared to the risk of the
financial returns to the general stock market. In the absence of debt, β measures the volatility of a firm’s financial return to

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changes in the general market’s overall financial return. Such a measure of volatility or risk is called an unlevered β and is

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denoted as βu. Increasing leverage will raise the level of uncertainty associated with shareholder returns and increase the value of

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β. However, this will be offset to some extent by the tax deductibility of interest, which reduces shareholder risk by increasing

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after-tax cash flow available for shareholders. A beta reflecting the effects of both the increased volatility of earnings and the
tax-shelter effects of leverage is called a leveraged or levered βl.
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7-3. Under what circumstances is it important to adjust the Capital Asset Pricing Model for firm size? Why?
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Answer: Small firms tend to be subject to higher default risk and are often less liquid than larger firms. Studies show that the
size of a firm is a good proxy for such factors. Since the CAPM reflects only non-diversifiable or market-related risk, it should
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be adjusted to reflect these factors.

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7-4. What are the primary differences between FCFE and FCFF?

Answer: Free cash flow to the firm represents cash available to satisfy all investors holding claims against the firm’s resources.
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In the FCFF formulation, there is no effort to adjust for payments of interest or preferred dividends, because this measure of cash
flow is calculated before any consideration is given to how expenditures will be financed. Under this definition, only cash flow
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from operating and investment activities, but not financing activities, is included. The tax rate refers to the firm’s marginal tax
rate. Depreciation expense used in all the formulae employed in this book is assumed to include all amortization expense. Free
cash flow to equity investors is the cash flow remaining for paying dividends to common equity investors or for reinvesting in
the firm after the firm satisfies all obligations. These obligations include debt payments, capital expenditures, changes in net
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working capital, and preferred dividend payments.

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7-5. Explain the conditions under which it makes most sense to use the zero growth and constant growth DCF models. Be specific.

Answer: While often overly simplistic, the zero growth model may be used because it is the most easily understood. Further,
there is no guarantee that more sophisticated valuation methods will provide a more accurate estimate. The zero growth model is
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commonly used in valuing commercial real estate. The constant growth model is appropriate for valuing businesses whose cash
flows have been growing a relatively constant rate historically, such as the beverage or household products industries.

7-6. Which discounted cash flow valuation methods require the estimation of a terminal value? Why?

Answer: The variable growth model, which consists of the present value of the annual cash flows forecasted during the forecast
period plus the present value of all those cash flows generated in the years beyond the forecast period. The later component is

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 referred to as the terminal or horizon value. Failure to estimate the terminal value implicitly assumes that the cash flows
generated by the business terminate with the last year of the forecast period.

7-7. 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?

Answer: Yes, small changes in the discount rate or terminal period growth rate can have dramatic changes in the magnitude of
the terminal value and in turn total present value. This occurs because small changes in the value of the denominator (i.e., cost
of capital less growth rate using the Gordon Growth Model) magnify the estimate of the PV of the numerator. If the terminal
value constitutes the bulk of the total present value of the firm, the analyst should extend the number of years during which
annual cash flows are projected.

7-8. How would you estimate the equity value of a firm if you knew its enterprise value and the present value of all non-operating
assets, non-operating liabilities, and long-term debt?

Answer: Subtract the PV of all non-operating liabilities and long-term debt from the enterprise value and add the PV on non-
operating assets.

7-9. Why is it important to distinguish between operating and on-operating assets and liabilities when valuing a firm? Be

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specific.

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Answer: Operating assets and liabilities are directly associated with generating a firm’s free cash flow. Free cash flow is

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subsequently projected and discounted at the firm’s cost of capital to estimate the firm’s current operating value. However, a
firm may have a substantial number of assets and liabilities that are not specifically identified on the firm’s balance sheet but

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which may add or detract from the firm’s current value. Failure to incorporate non-operating assets and liabilities into the
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valuation of the firm may result in a significant under or over-estimate of the firm’s true value.
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7-10. Explain how you would value a patent under the following situations: a patent without any current application, a patent linked to
an existing product, and a patent portfolio.
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Answer: Many firms have patents for which no current application within the firm has yet been identified. However, the patent
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may have value to an external party. Prior to closing, the buyer and seller may negotiate a value for a patent that has not yet been
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licensed to a third party based on the cash flows that can reasonably be expected to be generated over its future life. In cases
where the patent has been licensed to third parties, the valuation is based on the expected future royalties that are to be received
from licensing the patent over its remaining life.

When a product is used internally to produce a product, it is normally valued based on the ‘‘avoided cost’’ method. This method
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uses market-based royalty rates paid on comparable patents multiplied by the projected future stream of revenue from the
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products whose production depends on the patent discounted to its present value.

A firm may receive an exclusive right to an invention in return for helping the inventor develop the invention, developing and
marketing products based on the invention, and paying the inventor a royalty on future sales. The patent license agreement is
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valued as if the licensee owns the patent. Cash flows generated, because of the patent, are reduced by any lump sum or royalty
payments made in accordance with the license agreement.
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Products and services often depend upon a number of patents. This makes it exceedingly difficult to determine the amount of the
cash flow generated by the sale of the products or services to be allocated to each patent. In this case, the patents are grouped
together as a single portfolio and valued as a group using a single royalty rate applied to a declining percentage of the company’s
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future revenue and then this cash flow stream is discounted to its present value. Using a declining percentage of revenue reflects
the probable diminishing value of the patents with the passage of time.

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 Answers to End of Chapter Practice Problems

7-11. ABC Incorporated shares are currently trading for $32 per share. The firm has 1.13 billion shares outstanding. In addition, the
market value of the firm’s outstanding debt is $2 billion. The 10-year Treasury bond rate is 6.25%. ABC has an outstanding
credit record and has earned an AAA rating from the major credit rating agencies. The current interest rate on AAA corporate
bonds is 6.45%. The historical risk premium for stocks over the risk-free rate of return is 5.5 percentage points. The firm’s beta
is estimated to be 1.1 and its marginal tax rate, including federal, state, and local taxes is 40%.

a. What is the cost of equity?

b. What is the after-tax cost of debt?
c. What is the cost of capital?

Answers:
a. 12.3%
b. 3.9%
c. 11.9%
COE = .0625 + 1.1 (.055) = .123
i(after-tax cost of debt) = .0645 x (1-.4) = .039

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COC = {(32x1.13)/38.16} x .1230 + {2.0/38.16} x .039 = .1166 + .002 = .119

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7-12. HiFlyer Corporation does not currently have any debt. Its tax rate is .4 and its unlevered beta is estimated by examining

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comparable companies to be 2.0. The 10-year Treasury bond rate is 6.25% and the historical risk premium over the risk free rate
is 5.5%. Next year, HiFlyer expects to borrow up to 75% of its equity value to fund future growth.

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a.
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Calculate the firm’s current cost of equity.
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b. Estimate the firm’s cost of equity after it increases its leverage to 75% of equity?

Answers:
a. 17.25%
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b. 22.2%
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COE = .0625 + 2.0 (5.5) = .1725

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COE (with leverage) = .0625 + Bl (5.5), where Bl = Bu(1+(D/E)(1-t)) =2.0(1+(.75)(.6)) = 2.9

= .0625 + 2.9(.055) = .222
7-13. Abbreviated financial statements are given for Fletcher Corporation in the following table:
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2001 2002
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Revenues $600.0 $690.0

Operating expenses 520.0 600.0
Depreciation 16.0 18.0
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Earnings before 64.0 72.0

interest and taxes
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Less Interest Expense 5.0 5.0

Less: Taxes 23.6 26.8
Equals: Net income 35.4 40.2
Addendum:
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Y/E working capital 150 200

Principal repayment 25.0 25.0
Capital expenditures 20 10

Year-end working capital in 2000 was $160 million and the firm’s marginal tax rate is 40% in both 2001 and 2002. Estimate the
following for 2001 and 2002:
a. Free cash flow to equity.
b. Free cash flow to the firm.

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 Answers:
a. $16.4 million in 2001 and $(26.8) million in 2002
b. $44.4 million in 2001 and $1.2 million in 2002

FCFE2001= NI + Dep – Capex – Chg WC – Principal Repayments

= 35.4 + 16 – 20 – (150-160) – 25 = 16.4
FCFE2002 = 40.2 + 18 – 10 – (200 –150) –25 = -26.8
FCFF2001 = EBIT (1-t) + Dep –Capex – Chg. WC = 64 (1-.4) + 16 – 20 – (150-160) = 44.4
FCFF2002 = 72 (1-.4) + 18 – 10 – (200-150) = 1.2

7-14. No Growth Incorporated had operating income before interest and taxes in 2002 of $220 million. The firm was expected to
generate this level of operating income indefinitely. The firm had depreciation expense of $10 million that same year. Capital
spending totaled $20 million during 2002. At the end of 2001 and 2002, working capital totaled $70 and $80 million,
respectively. The firm’s combined marginal state, local, and federal tax rate was 40% and its debt outstanding had a market
value of $1.2 billion. The 10-year Treasury bond rate is 5% and the borrowing rate for companies exhibiting levels of

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creditworthiness similar to No Growth is 7%. The historical risk premium for stocks over the risk free rate of return is 5.5%. No

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Growth’s beta was estimated to be 1.0. The firm had 2,500,000 common shares outstanding at the end of 2002. No Growth’s
target debt to total capital ratio is 30%.

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a. Estimate free cash flow to the firm in 2002.

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b. Estimate the firm’s cost of capital.
c.
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Estimate the value of the firm (i.e., includes the value of equity and debt) at the end of 2002, assuming that it will
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generate the value of free cash flow estimated in (a) indefinitely.
d. Estimate the value of the equity of the firm at the end of 2002.
e. Estimate the value per share at the end of 2002.
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Answers:
a. $112 million
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b. 8.61%
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c. $1.300.8 billion
d. $100.8 million
e. $40.33
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a. FCFF2002 = 220x(1-.4) + 10 –20 – (80-70) = 132 + 10 –20 –10 = 112 million

b. COE = .05 + 1.0(.055) = 10.5
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COC = .70 x .105 + .07 x (1-.4) x .3 = .0735 + .0126 = .0861

c. PV = 112,000,000/.0861 = 1,300,813,008
d. Equity Value = $1,300.8 - $1,200.0 = $100.8 million
e. Equity value per share = 100.8/2.5 = $40.33
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7-15. Carlisle Enterprises, a specialty pharmaceutical manufacturer, has been losing market share for three years since several key
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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
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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?

Answer: $17.4 million

PV = 8.5/1.15 + 7.0/1.152 + 5/1.153 + 2/1.154 + .5/1.155

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 = 7.39 + 5.29 + 3.29 + 1.14 +.25 = 17.4

7-16. Ergo Unlimited’s current year’s free cash flow is $10 million. It is projected to grow at 20% per year for the next five years. It is
expected to grow at a more modest 5% beyond the fifth year. The firm estimates that its cost of capital is 12% during the next
five years and then will drop to 10% beyond the fifth year as the business matures. Estimate the firm’s current market value.

Answer: $358.30

PV1-5 = 10(1.2)/1.12 + 10(1.2)2/1.122 + 10(1.2)3/1.123 + 10(1.2)4/1.124 + 10(1.2)5/1.125

= 10.71 + 11.48 + 12.30 + 13.18 + 14.12 = 61.79

PVtv = 10(1.20)5x1.05/(.10-.05) = 522.55 = 296.51

1.125 1.125

Total PV = 61.79 + 296.51 = 358.30

7-17. 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

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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

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average debt/equity ratio is 20%. The firm is managed very conservatively and does not intend to borrow through the

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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

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discount rate is expected to decline to the industry average cost of capital of 10.4%. Estimate the value of the firm’s equity.
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a. βu (unlevered beta) for comparable firms = ____βl_____ = ___1.5___ = 1.5 = 1.34
(1 + D/E (1-t)) (1 + .2 x .6) 1.12
b. COE1-5 = Rf + βu (Rm – Rf) = .06 + 1.34 (.055) = 13.4%
c. Projected free cash flows (FCFE) to the firm during the next five years and for the terminal year are as follows:
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Year 1 2 3 4 5 Terminal
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Year
Net Income $2.40 $2.88 $3.46 $4.15 $4.98 $5.23

P0,1-5 = $2.4/1.134 + $2.88/(1.134)2 + $3.46/(1.134)3 + $4.15/(1.134)4 + $4.98/(1.134)5 =

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= $2.40/1.134 + $2.88/1.29 + $3.46/1.46 + $4.15/1.65 + $4.98/1.88 =

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= $2.12 + $2.23 + $2.37 + $2.52 + $2.65

= $11.89
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PTV = Terminal Value = {$5.23 / (.104 - .05)}/1.13455 = {$5.23 / .054}/1.88 = $96.85/1.88 = $51.52
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Total PV0 = $11.89 + $51.52 = $63.41

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7-18. The following information is available for two different common stocks: company A and Company B.

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 Company A Company B
Free cash flow per share $1.00 $5.00
at the end of year 1
Growth rate in cash flow 8% 4%
per share
Beta 1.3 .8
Risk-free return 7% 7%
Expected return on all 13.5% 13.5%
stocks

a. Estimate the cost of equity for each firm.

b. Assume that the companies’ growth rates will continue at the same rate indefinitely. Estimate the per share value of
each companies common stock.

Answer:

a. 15.45%

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b. 12.3%

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Answer:

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a. Company A: 7 + 1.3 (13.5-7) = 7+8.45=15.45%

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Company B: 7 + .8 (13.5-7.) = 7 + 5.2 = 12.2%
b.
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Company A: P= $1.00 / (.154-.08) = $13.50
Company B: P=$5.00 / (.122-.04) = $5.00/.082 =$61
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7-19. You have been asked to estimate the beta of a high-technology firm, which has three divisions with the following characteristics.
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Division Beta Market Value

Personal Computers 1.6 $100 million
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Software 2.00 $150 million

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Computer Mainframes 1.2 $250 million

a. What is the beta of the equity of the firm?

b. If the risk free return is 5% and the spread between the return on all stocks is 5.5%, estimate the cost of equity for the
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software division?
c. What is the cost of equity for the entire firm?
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d. Free cash flow to equity investors in the current year (FCFE) for the entire firm is $7.4 million and for the software
division is $3.1 million. If the total firm and the software division are expected to grow at the same 8% rate into the
foreseeable future, estimate the market value of the firm and of the software division.
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Answer:
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a. 1.52
b. 16%
c. 13.4%
d. PV (total firm) = $147.96
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PV (software division) = $41.75

Answer:
a. Beta = 1.6 x 100/500 + 2.00 x 150/500 + 1.2 x 250/500 =1.52
b. COE (software division) = .05 + 2.0 (.055) = 16%
c. COE (entire firm) = .05 + 1.52 (.055) = 13.4%
d, PV (total firm) = $7.4 (1.08) / (.134 - .08) = 7.99/.054 = $148
PV (software division) = $3.1 (1.08) / (.16 - .08) = $3.35 / .08 = $41.85

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 7.20. Financial Corporation wants to acquire Great Western Inc. Financial has estimated the enterprise value of Great Western at $104
million. The market value of Great Western’s long-term debt is $15 million, and cash balances in excess of the firm’s normal
working capital requirements are $3 million. Financial estimates the present value of certain licenses that Great Western is not
currently using to be $4 million. Great Western is the defendant in several outstanding lawsuits. Financial Corporation’s legal
department estimates the potential future cost of this litigation to be $3 million, with an estimated present value of $2.5 million.
Great Western has 2 million common shares outstanding. What is the value of Great Western per common share?

Answer: $46.75/share

Answer: ($104 + $3 + $4 - $15 - $2.5) / 2 = $46.75

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