Mergers & Acquisitions

Professor Cronqvist

Final Exam

STUDENT NAME: _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

STUDENT ID: _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

 Do not open this exam until you get the go-ahead.

 The exam is closed book. No books or notes are permitted. Only a calculator is allowed.

 There are a total of 130 points.

 State any assumptions you make, and always show your calculations.

GOOD LUCK!
Shorter Questions
(3 points each)

1) The distribution for any multiple will tend to be asymmetric. Given that a multiple cannot be
less than zero but is unconstrained on the upside, which of the following would you expect to see
in the summary statistics?
A) The average should be higher than the median
B) The average should be lower than the median
C) The average will be roughly equal to the median
D) The average can be higher or lower than the median

2) You have run a regression of EV/EBITDA multiples across all companies in the market
and arrived at the following:
EV/EBITDA = 5+80x(Growth rateRevenues)-20x(Cost of capital)-12x(Effective tax rate).
Astor Inc. is a publicly traded company with EBITDA of $100 million and enterprise value of
$480 million; it has an expected growth rate in revenues of 6% for the next 5 years and a cost of
capital of 10%. Assuming that this stock is fairly priced, what is Astor’s effective tax rate?
A) 0%
B) 15%
C) 25%
D) 40%
E) None of the above

3) Allwyn Inc. is a stable growth, dividend-paying firm that is expected to pay out 60% of its
expected earnings per share of $1.50 next year as dividends. If the earnings are expected to grow
3% a year in perpetuity and the cost of equity is 9%, what PE ratio would you expect the firm to
have?
A) 6.00
B) 9.00
C) 10.00
D) 20.00

4) If you are dividing the market capitalization by book value to arrive at a price to book value
ratio for a company, which of the following will you use as your measure of book value?
A) Book value of assets
B) Book value of liabilities
C) Book value of common equity
D) Book value of invested capital (debt + equity – cash)

5) Suppose that you estimate the Equity Risk Premium for the U.S. for the period 1928 to 2011
to be 6.5%. Suppose the annual standard deviation of S&P 500 return were 20% for this period.
What is your 95% confidence interval for the MRP in the U.S.
A) 4.3 to 8.7%
B) 6.5% +/- 4.4%
C) 0.0% to 10.5%
D) The ERP is exactly 6.5%
6) You obtain the “adjusted” beta for Wal-Mart from a Bloomberg terminal. It is 1.0. What is
the “raw” beta you would obtain from a standard regression?
A) 1.33
B) 0.67
C) 1.00
D) None of the above

7) You are valuing a Spanish company in Euros. Which of the following would you use as your
risk free rate in your valuation?
A) The rate on Spanish government ten-year euro bond
B) The highest of the 10-year, euro denominated government bond rates
C) The lowest of the 10-year, euro denominated government bond rates
D) The lowest of the European government bond rates, which is the Swiss Government bond
rate, denominated in Swiss francs

8) Wayfarers Inc. is a risky technology company that is expected to have a cost of capital of 12%
for the next 10 years. At the end of year 10, it is anticipated that the firm will become a mature
company, earning a return on invested capital equal to its stable period cost of capital of 10% in
perpetuity. If the expected after-tax operating income in year 11 is $80 million and the expected
growth rate in perpetuity is 3%, estimate the present value of the terminal value at the end of
year 1.
A) $257.58 million
B) $308.43 million
C) $367.97 million
D) $440.62 million
E) None of the above

9) You are trying to compute the change in working capital to use in computing free cash flow to
the firm for Zapata Inc. The firm’s total working capital increased from $100 million last year to
$120 million this year. However, this working capital includes cash and short term debt; last
year’s cash balance had $30 million in cash and $15 million in short term debt, whereas this
year’s cash balance has $20 million in cash and $25 million in short term debt. What effect did
working capital have on your cash flow this year?
A) Decreased cash flow by $20 million
B) Decreased cash flow by $30 million
C) Decreased cash flow by $35 million
D) Decreased cash flow by $40 million

10) The stable growth rate cannot be negative.

11) You are analyzing Sterling Stores, a retail company. The company reported $25 million in
pre-tax operating income in the most recent year and invested capital of $125 million. The
operating income, though, was computed after operating lease expenses that amounted to $25
million in the most recent year and the company has commitments to make $20 million in lease
payments every year for the next 8 years. Assuming that Sterling Stores has a pre-tax cost of debt
of 4% and that you decide to capitalize operating leases, what is the pre-tax return on capital is
for Sterling Stores?
A) 26.53%
B) 10.53%
C) 19.26%
D) 12.77%
E) None of the above

12) Nowitzki Inc. is a publicly traded company that owns 60% of Bowden Inc, another publicly
traded firm. You have valued the operating assets of Nowitzki by discounting the cash flows
(from Nowitzki’s consolidated financials) at the cost of capital to arrive at a value of $1 billion
for the operating assets. Nowitzki reports debt of $200 million and cash of $100 million on its
consolidated balance sheet. While Nowitzki also shows a minority interest of $120 million on the
balance sheet, you believe that the intrinsic value of all of Bowden’s equity is closer to $500
million. Estimate the value of equity for Nowitzki.
A) $700 million
B) $1.1 billion
C) $880 million
D) $1,120 million

13) Investments that are less liquid are usually valued lower than otherwise similar liquid
investments. Which of the following is a way of incorporating the effect of illiquidity on value.
A) Use a lower discount rate for the illiquid asset and reduce the DCF value by an illiquidity
discount.
B) Use a higher discount rate for the illiquid asset and reduce the DCF value by an illiquidity
discount.
C) Use the same discount rate for the illiquid asset (as you would for a liquid asset) and reduce
the DCF value by an illiquidity discount.
D) Use a lower discount rate for the illiquid asset and don’t adjust the DCF value.

14) Which of the following motives for mergers are least likely makes economic sense?
A) Surplus funds and vertical integration.
B) Complementary resources and eliminating inefficiencies.
C) Diversification and reduced borrowing costs.

15) Publicly traded companies often accumulate cash that is usually invested in riskless, liquid
securities that yield low returns. Which of the following is a good reason for punishing
companies that hold cash (by discounting the cash)?
A) The cash earns a lower rate of return than the cost of equity.
B) The cash earns a lower rate of return than investments in operating assets.
C) Investors can earn a higher return on the cash, if it was returned to them.
D) None of the above.
Question 16. (30 points)

a) What are the fundamental determinants of the Price-to-Book (PB) ratio? Show your
calculations.

You are analyzing LM Cement, a publicly traded company in Latin America. You have
estimated the firm’s PB ratio at 1.80 and you believe that the company will generate 20% as its
return on equity (in US $ terms) forever. The firm is in stable growth and expects to grow 5% (in
US $ term) a year in perpetuity. The risk-free rate in US dollars is 5%, the equity risk premium
for mature markets is 4% and the levered beta for the firm is 1.00.

b) Assuming that the current market value is correct, estimate the additional risk premium that is
being charged because this company is an emerging market company.

c) As an alternative, you run a regression of the price to book ratios of cement companies against
their returns on equities and whether they are emerging market or developed market companies:
PB = 0.90 + 0.06xROE – 0.40x(Emerging Market Indicator Variable), where the ROE is entered
as an absolute value (15% would be entered as 15) and the Emerging Market Indicator Variable
is 1 for emerging market companies, and 0 otherwise. Is the stock under or over priced relative to
the sector? Show your calculations.
Question 17. (35 points)

You have been asked to analyze a deal in which A Inc. would acquire B Inc., and have been
provided the following information on them (with all dollar values in millions):

A B Inc.
Inc.
Revenues $2,00 $1,000
0
Expected EBIT next year $200 $150
Tax rate 40% 40%
Beta (levered) 1.2 1.2
Debt to value ratio 20% 20%
Cost of equity 9.20 9.20%
%
Pre-tax cost of debt 4.00 4.00%
%
Expected growth rate & risk-free rate 2% 2%
Invested capital $1,20 $900
0

Assume an Equity Risk Premium of 6.00%.

a) Compute the reinvestment rate (RIR) for A Inc. and B Inc., respectively.

b) Assume that the combined company will be able to cut SG&A expenses (overhead) by $70
million next year, while keeping expected growth intact. In addition, the combined company
will be able to use its larger size (and stability) to increase its debt to capital ratio to 30%,
without affecting its pre-tax cost of debt. Estimate the value of synergies in this merger.
c) The current market capitalization of B Inc. is $1.5 billion. What is the synergy premium (in
%) that would transfer the entire synergy to the target shareholders?
Question 18. (20 points)

In class, we discussed “Seven Sins in Acquisitions.” Please state and discuss four of them.