Hager’s Home Repair Company, a regional hardware chain that specializes in “do it yourself” materials and equipment rentals, is cash rich because of several consecutive good years. One of the alternative uses for the excess funds is an acquisition. Doug Zona, Hager’s treasurer and your boss, has been asked to place a value on a potential target, Lyons Lighting (LL), a chain that operates in several adjacent states, and he has enlisted your help.

The table below indicates Zona’s estimates of LL’s earnings potential if it came under Hager’s management (in millions of dollars). The interest expense listed here includes the interest (1) on LL’s existing debt, which is $55 million at a rate of 9%, and (2) on new debt expected to be issued over time to help finance expansion within the new “L division,” the code name given to the target firm. If acquired, LL will face a 40% tax rate.

Security analysts estimate LL’s beta to be 1.3. The acquisition would not change Lyons’s capital structure, which is 20% debt. Zona realizes that Lyons Lighting’s business plan also requires certain levels of operating capital and that the annual investment could be significant. The required levels of total net operating capital are listed in the table.

Zona estimates the risk-free rate to be 7% and the market risk premium to be 4%. He also estimates that free cash flows after 2015 will grow at a constant rate of 6%. Following are projections for sales and other items.

Hager’s management is new to the merger game, so Zona has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Zona has developed the following questions, which you must answer and then defend to Hager’s board.

a. Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax considerations, (2) risk reduction, (3) control, (4) purchase of assets at below replacement cost, (5) synergy, and (6) globalization. In general, which of the reasons are economically justifiable? Which are not? Which fit the situation at hand? Explain.
b. Briefly describe the differences between a hostile merger and a friendly merger.
c. What are the steps in valuing a merger?
d. Use the data developed in the table to construct the L division’s free cash flows for 2011 through 2015. Why are we identifying interest expense separately when it is not normally included in calculating free cash flows or in a capital budgeting cash flow analysis? Why is investment in net operating capital included when calculating the free cash flow?
e. Conceptually, what is the appropriate discount rate to apply to the cash flows developed in part c? What is your actual estimate of this discount rate?
f. What is the estimated horizon, or continuing, value of the acquisition; that is, what is the estimated value of the L division’s cash flows beyond 2015? What is LL’s value to Hager’s shareholders? Suppose another firm were evaluating LL as an acquisition candidate. Would it obtain the same value? Explain.
g. Assume that LL has 20 million shares outstanding. These shares are traded relatively infrequently, but the last trade (made several weeks ago) was at a price of $11 per share. Should Hager’s make an offer for Lyons Lighting? If so, how much should it offer per share?
h. How would the analysis be different if Hager’s intended to recapitalize LL with 40% debt costing 10% at the end of 4 years? This amounts to $221.6 million in debt as of the end of 2014.
i. There has been considerable research undertaken to determine whether mergers really create value and, if so, how this value is shared between the parties involved. What are the results of this research?
j. What method is used to account for mergers?
k. What merger-related activities are undertaken by investment bankers?
l. What is a leveraged buyout (LBO)? What are some of the advantages and disadvantages of going private?
m. What are the major types of divestitures? What motivates firms to divest assets?
n. What are holding companies? What are their advantages and disadvantages?