Simon Corporation is considering the acquisition of Ingram
Company. Ingram has a capital structure
consisting of $7.5 million (market value) of 11% bonds and $15 million (market value) of common stock.
Ingram's pre-merger beta is 1.36. Simon's beta is 1.02, and both it and Ingram face a 40% tax rate.
Simon's capital structure is 40% debt and 60% equity. The free cash flows from Ingram are estimated to be
$4.5 million for each of the next 4 years and a horizon value of $15 million in Year 4. Tax savings are
estimated to be $1.5 million for each of the next 4 years and a horizon value of $7.5 million in Year 4. New debt
would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of
8%. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.
What is the value of Ingram’s equity to Simon? A)$25.66 million B)$27.111 million C)$17.111 million
Solution:
Calculation of discount rate of Simon:
Cost of new debt = 8%
Tax rate = 40%
After tax cost of bond [8% * (1 – 40%)] = 4.80%
Simon’s pre-merger beta = 1.02
Risk-free rate = 6%
Risk premium = 4%
As per CAPM, Rf + β x (Rm - Rf) = 6% + 1.02 x 4% = 10.08%
|
Type |
Rate |
Weights |
WACC |
|
Bond |
4.80% |
40% |
1.92% |
|
Equity |
10.08% |
60% |
6.05% |
|
7.97% |
Free cash flow for 4 years = $4.5 million
Horizon value after 4 years = $15 million
Value of Ingram’s equity to Simon
= Present Value of free cash flow – Value of debt of Ingram
= $4.5 million * PVIFA (7.97%, 4 years) + $15 million / (1.0797) ^ 4 - $7.5 million
= $18.4521 million
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