Smitty’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. Linda Wade, Smitty’s treasurer and your boss, has been asked to place a value on a potential target, Hill’s Hardware, a small chain that operates in an adjacent state, and she has enlisted your help. 

The table below indicates Wade’s estimates of Hill’s earnings potential if it came under Smitty’s management (in millions of dollars). The interest expense listed here includes the interest (1) on Hill’s existing debt, (2) on new debt that Smitty’s would issue to help finance the acquisition, and (3) on new debt expected to be issued over time to help finance expansion within the new “H division,” the code name given to the target firm. The retentions represent earnings that will be reinvested within the H division to help finance its growth.

Hill’s Hardware currently uses 40 percent debt financing, and it pays federal-plus-state taxes at a 30 percent rate. Security analysts estimate Hill’s beta to be 1.2. If the acquisition were to take place, Smitty’s would increase Hill’s debt ratio to 50 percent, which would increase its beta to 1.3. Further, because Smitty’s is highly profitable, taxes on the consolidated firm would be 40 percent. Wade realizes that Hill’s Hardware also generates depreciation cash flows, but she believes that these funds would have to be reinvested within the division to replace worn-out equipment.

Wade estimates the risk-free rate to be 9 percent and the market risk premium to be 4 percent. She also estimates that net cash flows after 2009 will grow at a constant rate of 6 percent. Smitty’s management is new to the merger game, so Wade has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Wade has developed the following questions, which you must answer and then defend to Smitty’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, and (5) synergy. 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. Use the data developed in the table to construct the H division’s cash flow statements for 2006 through 2009. Why is interest expense deducted in merger cash flow statements, whereas it is not normally deducted in a capital budgeting cash flow analysis? Why are earnings retentions deducted in the cash flow statement?

d. 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?
e. What is the estimated terminal value of the acquisition; that is, what is the estimated value of the H division’s cash flows beyond 2009? What is Hill’s value to Smitty’s? Suppose another firm were evaluating Hill’s as an acquisition candidate. Would they obtain the same value? Explain.
f. Assume that Hill’s has 10 million shares outstanding. These shares are traded relatively infrequently, but the last trade, made several weeks ago, was at a price of $9 per share. Should Smitty’s make an offer for Hill’s? If so, how much should it offer per share?
g. What merger-related activities are undertaken by investment bankers?