Question

Following is a table of projected after tax cash flows, their respective discount rates, and values after the acquisition of DrugShop Limited (DSL) by Lawslob Enterprises (LLE). Fill in the blanks and calculate the stock price of the new firm if it has debt/equity ratio of 3/5 and 100 million shares outstanding.

                                                        Net Cash Flow

                                                       ($ million) starting Growth                    Discount Value

                                                       one year from now Rate (%)                 Rate (%) ($ million)

DSL (on its own)                         180                                  3 ---- 1500

LLE (on its own)                          800                                 -2                        10.5 ----

Acquisition Benefits                      49                                   4                         ---- 500

            Rev. Enhancement             20                                  6                          14 ----

            Cost Reduction                  20                                   4                          16.5 ----

            Tax Shelters                       9                                     2                          12 ----

DSL+LLE                                   1029                                  2 ---- ----

Answer 1

DSL Value (standalone) = $ 1500 million

LLE Net Cash Flow = $ 800 million, Growth Rate = - 2 % and Discount Rate = 10.5 %

LLE Value (Standalone) = 800 / (0.105-(-2)) = $ 6400 million

Acquisition Benefits Value = $ 500 million

Total Combined Firm Value = DSL Value + LLE Value + Acquisition Benefits = 1500 + 6400 + 500 = $ 8400 million

Combined Net Cash Flow = $ 1029 million and Combined firm growth rate = 2 %

Let the discount rate be r for the combined firm

Therefore, 8400 = 1029 / (r-0.02)

r = 0.1425 or 14.25%

Debt - Equity Ratio of Combined Firm = 3/5

Debt Value = (3/8) x 8400 = $ 3150 million and Equity Value = (5/8) x 8400 = $ 5250 million

Number of Outstanding Shares = 100 million

Stock Price of Combined Firm = 5250 / 100 = $ 52.5