A sporting goods manufacturer has decided to expand into a related business. Management estimates that to build and staff a facility of the desired size and to attain capacity operations would cost $450 million in present value terms. Alternatively, the company could acquire an existing firm or division with the desired capacity. One such opportunity is a division of another company. The book value of the division’s assets is $250 million and its earnings before interest and tax are presently $50million. Publicly traded comparable companies are selling in a narrow range around 12 times current earnings. These companies have book value debt-to-asset ratios averaging 40 percent with an average interest rate of 10 percent.
a. Using a tax rate of 34 percent, estimate the minimum price the owner of the division should consider for its sale.
b. What is the maximum price the acquirer should be willing to pay?
c. Does it appear that an acquisition is feasible? Why or why not?
d. Would a 25 percent increase in stock prices to an industry average price to earnings ratio of 15 change your answer to (c)? Why or why not?
e. Referring to the $450 million price tag as the replacement value of the division, what would you predict would happen to acquisition activity when market values of companies and divisions rise above their replacement values?