9. Frozen North Outfitters Inc. makes thermal clothing for winter sports and outdoor work. It is considering acquiring Downhill Fashions Corp., which manufactures and sells ski clothing. Downhill is about one-quarter of Frozen’s size and manufactures its entire product line in a small rented factory on a mountaintop in Colorado. It costs about $1 million a year in overhead to operate in that factory.

Frozen produces its output in a less romantic but more practical southern location.

Its factory has at least 50% excess capacity. Frozen’s plan is to acquire Downhill and combine production operations in its southern factory, but otherwise run the companies separately.

Downhill’s beta is 2.0, treasury bills currently yield 5%, and the Standard and Poor’s 500 Index is yielding 9%. The marginal combined federal and state income tax rate for both firms is 40%. Because Downhill will no longer be maintaining its own production facilities, only a minimal amount of cash will have to be reinvested to keep its equipment current and for future growth. This amount is estimated at $100,000 per year. Selected financial information for Downhill follows.

Revenue $12,500,000 EAT 1,300,000 Depreciation 600,000

a. Calculate the appropriate discount rate for evaluating the Downhill acquisition.

b. Determine the annual cash flow expected by Frozen from Downhill if the acquisition is made (don’t forget to include the synergy).

c. Calculate the value of the acquisition to Frozen assuming the benefits last for

(1) 5 years, (2) 10 years, and (3) 15 years.

d. Downhill has 250,000 shares of stock outstanding. Calculate the maximum price Frozen should be willing to pay per share to acquire the firm under the three assumptions in part (c).

e. If Frozen is willing to assume the benefits of the Downhill acquisition will last indefinitely but not grow, what should it be willing to pay per share?