EC 4/Zenginobuz
Spring 201
Valuation of debt financed repurchasing of shares
The ABC Corporation is currently an all-equity firm. ABC’s assets generate a constant,
perpetual cash flow stream with an EBIT of $30 million (M). It reinvests an amount
each year exactly equal to its annual depreciation expense of $1M. It pays out in
dividends the constant amount of cash after taxes and investment each year. ABC has
1M shares outstanding. The required return on similar all-equity firms is 18%. The
corporate tax rate is 34%. Interest expense is deductible for tax purposes.
The CFO of ABC is considering a recapitalization plan through which ABC is expected
to raise 50M at the risk free rate of 10%. The proceeds of the debt will be used to
repurchase the firm’s shares.
a) Calculate the value of ABC and the price of its shares before the recapitalization
plan is announced and implemented.
b) What will be the value of the company and the price of its shares when the
recapitalization plan is announced?
c) When ABC carries out its recapitalization, how many shares will it be able to
repurchase with the $50M it will raise?
d) What will be the earnings per share (EPS) after the completion of recapitalization
plan?
e) Calculate the post-recapitalization required return on equity (rE) and verify the postrecapitalization price you calculated in b) using the EPS you calculated in d) and rE.
f) Calculate the weighted average cost of capital (r* or WACC) for ABC after the
recapitalization. Use this rate and unlevered free cash flows of ABC (that is,
EBIT (1 − τ ) ) to verify the total post-recapitalization (or levered) value of ABC.
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Department of Economics
Boğaziçi University
Economics of Corporate Finance
EC 423
Ünal Zenginobuz
Spring 2015
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Mini Case #1: Valuing a Business Acquisition Opportunity
(Due May 6, 2015)
Calculating the NPV of a business acquisition opportunity is conceptually similar to a
capital budgeting analysis for a (machine) replacement project. As in valuing a typical
investment opportunity, one is to discount the annual cash flows over the life of the
investment at the appropriate cost of capital.
However, there are some special features of a business acquisition analysis that one has
to pay attention to. Firstly, the life of a business acquisition project is typically not finite
(i.e. the business is typically not going to end in a foreseeable future). Second, when a
growing business is acquired, the annual cash flows are typically relatively small, and
sometimes even negative, for the first 5- to 15-year planning horizon typically used in
capital budgeting analysis. These two features make the assumptions about “terminal
value” critical to NPV analysis of a business acquisition.
The small case study below will ask you to check the impact of several different
methods used for determining the terminal value of a business acquisition.
Table 1 below presents six years of actual and pro-forma figures relating to a business
acquisition opportunity. The firm under consideration has just completed the year 2002
in which sales reached $50 million. Sales are expected to grow at 5% per year over the
next five years. Growth may continue at the 5% annual rate beyond year five. The firm
requires $0.40 of net working capital per dollar of incremental sales, and $0.50 of net
additions to property, plant, and equipment per dollar of incremental sales. The firm
depreciates its net investment in property, plant, and equipment at the rate of 10% a
year.
The book value of the firm’s capital at year-end 2002 is $30 million. The firm is an all
equity firm and has 1 million common shares outstanding and a stock price of $26/share
(therefore, the market value/book value ratio of the common stock is $26/$30 = 0.87).
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Question
The cash flows to capital from this business will not end in five years. You are asked to
compute the maximum amount that can be paid to acquire 100% of the shares of this
firm under different assumptions regarding “terminal value” as of the end of year five
that are stated below:
a) Terminal value as a growing perpetuity cash flow: Assume that the cash flows
continue to grow at the annual rate of 5% indefinitely into the future (as they
have done until the end of year five);
b) Terminal value as a stable perpetuity cash flow: Assume that the market in
which the firm operates will have matured by the end of year five, and, hence,
there will be no growth in sales after year five;
c) Terminal value as a multiple of book value: Calculate the terminal value of the
of the firm (as of the year end 2007) by multiplying the forecasted terminal-year
book value of invested capital by an appropriate market value/book value ratio.
Under the assumption that the profitability of the business is not going to change
over time, use the current market value/book value ratio of 0.87 (= $26 million
/$30 million) to find the terminal value in this case;
d) Terminal value as a multiple of earnings: Multiply the forecasted terminal year
profits by an appropriate price/earnings ratio. Under again the assumption that
the profitability of the business is not going to change, use the current (i.e. year
2002) price/earnings ratio of the firm for this purpose;
e) Terminal value in liquidation: Assume a liquidation value for the assets at the
end of the last year of planning horizon (end of year five in this case). Assume
that net working capital can be liquidated at cost, while property, plant, and
equipment might be liquidated at 50% of net book value (hence at 50% loss on
net book value).
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Table 1: Actual and Pro Forma Financial Data for the Firm to be Acquired
Actual
Pro Forma
2002 2003 2004 2005 2006 2007
Initial Sales
50.00
End of year PP&E (Property, Plant, and 25.00
Equipment)
End of Year NWC
20.00
End of Year Other Assets
0.00
Annual Growth Rates
Cost of Goods/Sales
0.62
SG&A/Sales (Selling, General, and 0.20
Administrative Costs /Sales)
Tax Rates
0.40
NWC/Sales
0.40
PP&E/Sales
0.50
Depreciation/PP&E
0.10
Other Assets/Sales
0.00
Discount Rate
0.10
4
0.05
0.62
0.20
0.05
0.62
0.20
0.05
0.62
0.20
0.05
0.62
0.20
0.05
0.62
0.20
0.40
0.40
0.50
0.10
0.00
0.40
0.40
0.50
0.10
0.00
0.40
0.40
0.50
0.10
0.00
0.40
0.40
0.50
0.10
0.00
0.40
0.40
0.50
0.10
0.00