-10- QUESTION 5: ABC Limited an all equity financed firm expects EBIT of $2,000,000 for the next two years and after that decline at 2% per year forever. ABC management would like to leverage the firm to increase its value. ABC has 40% corporate tax rate and the required rate of return is 10%. ABC has estimated the following probability distribution of bankruptcy at various debt levels. Perpetual Debt (millions of $s) 5 10 15 20 25 30 Probability of Bankruptcy (0) 0 2 8 30 50 75 Present value of bankruptcy related costs =$10,000,000 In the meantime XYZ Corporation which is also in 40% tax bracket is considering acquiring ABC. XYZ believes that after the acquisition ABC's EBIT will remain at $2,000,000 per year for the first two years and after that will start increasing at 3% per year forever. XYZ will finance ABC acquisition with both debt and equity. Whatever price XYZ will offer, $10,000,000 of that will be financed through perpetual debt. XYZ expects no risk of bankruptcy, if it doesn't borrow more than $15,000,000 to finance the acquisition The following information has been collected about XYZ Corporation: Price/Earning Ratio 20 Shares Outstanding 5,000,000 Earnings $5,000,000 a. At what debt level value management of ABC can maximize the ABC value? b. What is the value of ABC to XYZ? How much is the synergy? c. What is the minimum offer acceptable to ABC, and what is the maximum XYZ would be willing to offer. -10- QUESTION 5: ABC Limited an all equity financed firm expects EBIT of $2,000,000 for the next two years and after that decline at 2% per year forever. ABC management would like to leverage the firm to increase its value. ABC has 40% corporate tax rate and the required rate of return is 10%. ABC has estimated the following probability distribution of bankruptcy at various debt levels. Perpetual Debt (millions of $s) 5 10 15 20 25 30 Probability of Bankruptcy (0) 0 2 8 30 50 75 Present value of bankruptcy related costs =$10,000,000 In the meantime XYZ Corporation which is also in 40% tax bracket is considering acquiring ABC. XYZ believes that after the acquisition ABC's EBIT will remain at $2,000,000 per year for the first two years and after that will start increasing at 3% per year forever. XYZ will finance ABC acquisition with both debt and equity. Whatever price XYZ will offer, $10,000,000 of that will be financed through perpetual debt. XYZ expects no risk of bankruptcy, if it doesn't borrow more than $15,000,000 to finance the acquisition The following information has been collected about XYZ Corporation: Price/Earning Ratio 20 Shares Outstanding 5,000,000 Earnings $5,000,000 a. At what debt level value management of ABC can maximize the ABC value? b. What is the value of ABC to XYZ? How much is the synergy? c. What is the minimum offer acceptable to ABC, and what is the maximum XYZ would be willing to offer