As an analyst for J.P. Bank you were tasked to analyse a prospective acquisition deal whereby Hina Kachun Inc (referred to as Hina) wishes to acquire Ziel Incorporated (referred to as Ziel). Hina expects synergies in the form of cost savings and higher sales growth.

The 10-year Treasury bond rate is 2%, the equity risk premium is 5.5%, and the marginal tax rate is 21%. All growth numbers in this exercise are compounded annually.

Ziel Inc has the following characteristics for the current period:

• Revenue = $2,500 million
• Operating margin before tax= 5.00%
• Unlevered beta = 0.76
• Before tax cost of debt = 5.50%
• Debt ratio = 25%.

Operating income is expected to grow at the rate of 10% a year for the next five years. The Return on Capital (ROC) is equal to 40% and is expected to remain so for the next five years.

After Year 5, operating income is expected to grow at the rate of 3% a year forever, while the ROC as above is expected to stabilize at 20% forever.

To value control of Ziel assume that:

• Hina would raise Ziels debt ratio to its optimal level of 50%. Due to a reduction in operating leverage, the unlevered beta is expected to fall to 0.65 and new before- tax cost of debt becomes 6% given the higher company financial leverage.
• Hina would take Ziels pre-tax operating margin to 6.0%.

Hina Kachun Inc data is as follows for the current period:

• Revenue = $18,000 million
• Operating margin before tax = 4.0%
• Unlevered beta = 0.85
• Before tax cost of debt = 4.00%
• Debt ratio = 30%

• Operating income is expected to grow at the rate of 5% a year for the next five years. During the next five years, the reinvestment rate remains constant at 20%.

  After Year 5, operating income is expected to grow at 3% a year forever, while the reinvestment rate falls to 10% a year in perpetuity. The long-term strategy of the firm after Year 5 is to raise the debt ratio to 50%, this increase in debt will change the before-tax cost of debt to 5%.

  Note that the status quo value of Hina is given to you in question C6.

  The combined firm

  The operating margin of the combined firm will be 4.5%. The combined firm would also have a slightly higher growth rate of 7.00% in operating income over the next five years because of operating synergies, during which time the reinvestment of the combined firm would be the sum of the reinvestments of the two individual firms (simple average). The combined before tax cost of debt, unlevered Beta and debt to capital ratio are 5.25%, 0.85 and 50% respectively.

  After Year 5, the reinvestment rate stabilizes at 15%, while the operating income is expected to grow at 3% forever. The before tax cost of debt of the combined firm would fall to 5.00%. The unlevered beta of the combined firm is equal to 0.85 and remains unchanged forever. The debt to capital ratio of the combined firm is 50% forever.

  REQUIRED

  C1. The current WACC for Ziel (target firm) is 6.55%. Compute Ziel free cash flows to the firm (FCFF) during the high growth stage (next five years) and the terminal value right after this. Obtain the status quo value for Ziel. [8 marks]

  C2. If Hina would acquire Ziel (and increase Ziels debt level to 50%), WACC would change to 6.57%. Compute the free cash flows to the firm for Ziel during the high growth stage (next 5 years) and its terminal value to obtain Ziel firm value with improvements.

  [8 marks]

• C3: Compute the value of control. [2 marks]

  C4: Compute WACC of the combined firm during the high growth stage. [3 marks]

  C5: Compute the value of the combined firm by forecasting 5 years of high growth and the terminal value (stable stage) after this. Dont forget to include synergies in your FCFF!

  [8 marks]

  C6: The status quo value of Hina is $11,855 million. Assume that Ziel has 1,000 million shares outstanding and a market value of debt of $250 million.

• Calculate the maximum price per share that Hina should be willing to pay for Ziel if it takes two years for control and synergies to materialize. [5 marks]
• b) Calculate the premium that Hina would need to pay to acquire Ziel. [1 mark]

• Maximum price to pay = Target company status quo value (or market price if listed) + [(value of control + value of synergy) / (1+WACC)^n]

  Note for question C6