Question

Pursuing Myron Bronco: Wouldn’t it be good?:

It was right at the beginning of 2019. Myron Bronco Incorporation (MB) was a medium-sized company listed in a share market. Largely owned by a traditional and financially conversative elite family, the company operated in a lower-risk and mildly-competitive industry. With thin trading of its shares in the stock exchange, the family has been considerably successful in controlling major decisions/directions made by the company. The family-owners of the company also take pride with the fact the business has managed to stay constantly debt-free (long-term debt) for more than a decade or so.

In the same share market, there was an active group of hedge funds that seek for companies that can be easily turned around to create additional value. Circling Vulture Fund (CVF) was one of them. Surely and slowly enough, CVF has recently set its eyes on MB.

At the beginning of 2019, Genghis Smith, the managing partner of CVF projected the future (debt-free) free cash flows of MB as follows:

Year (End of year)	FCF
2019	16.2 mil
2020	18.9 mil
2021	21.6 mil
2022	24.3 mil
2023	27.0 mil
2024	29.7 mil
2025	32.4 mil

After 2025, yearly FCFs are projected to be perpetual and stay at 32.4 million $.

The Beta of MB from regression estimation (based on the past three-year daily data) is 0.75. The relevant risk-free rate and the market risk premium were 5% and 2% respectively. The treasury department of MB estimates the cost of debt if the company is to borrow to be 5.5% per year.

As observed in the beginning of 2019, share price of MB was 150 while EPS was 30. The number of shares outstanding was 5 million shares. The P/E ratio of the slow-growth industry MB belongs to was only 3.

The corporate tax rate is 21%.

Answer the following questions:

Genghis Smith, with the backup VCF, plans to take over (acquire the majority stake of Myron Bronco) and then re-leverage MB by issuing a 15 year corporate debt at the fixed interest rate of 5.5% per year. The plan is for MB to borrow towards its own industry’s average debt financing appeared in the accounting book (book-based D/E ratio of the industry is 1.8). The book value of equity of MB is 450 mil$. How much value can be added to MB Incorporation based on this proposal?

4) What is MB’s WACC after recapitalisation (based on CVF’s proposal)?

Answer 1

Based on a book value D/E ratio of 1.8 and book equity value of 450 million, debt which can be taken is

D/E ratio*book equity value = 1.8*450 = 810 million

So, additional value of 810 million can be added to MB if debt is taken on.

4). WACC = (Equity ratio*cost of equity) + (debt ratio*cost of debt)

D/E = 1.8 so E/V = 1/(1+1.8) = 0.3571

D/V = 1- E/V = 1 - 0.3571 = 0.6429

After-tax cost of debt = cost of debt*(1-tax rate) = 5.5%*(1-21%) = 4.35%

Unlevered beta = 0.75, so

levered beta = unlevered beta*(1 + D/E*(1-Tax rate)) = 0.75*(1 + 1.8*(1-21%)) = 1.8165

Cost of equity = risk-free rate + levered beta*market risk premium

= 5% + (1.8165*2%) = 8.63%

WACC after recapitalization = (0.3571*8.63%) + (0.6429*4.35%) = 5.88%