A capital goods manufacturer has decided to expand into a related business. Management estimates that to build and staff a facility of the desired size and attain capacity operations would cost $250 million in present value terms. Alternatively, the company could acquire an existing firm or division with the desired capacity. One such opportunity is the division of another company. The book value of the division's assets is $140, and its earnings before interest and tax are presently $30. Publicly traded comparable companies are selling in a narrow range around 13 times current earnings. These companies have 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 30 percent decline in stock prices to an industry average price-to-earnings ratio of 9.1 change your answer to part c? Why or why not?

e. Referring to the $250 million price tag as the replacement value of the division, what do you predict would happen to acquisition activity when market values of companies and divisions fell below their replacement values?

AppendixLO1