Brandy's & Danny's Danny's SuperFood Ltd. operates a chain of 200 supermarkets in the Mid-West. The company had had a lackluster record and, since the death of its founder in late 2000, it had been regarded as a prime target for a takeover bid. In anticipation of a bid, Danny's share price moved up from $ 4 in November to a 12-month high of $ 5 on December 31, 2002 despite the fact that the stock market index as a whole was largely unchanged. Almost nobody anticipated a bid coming from Brandy's, a large operator of chain of supermarkets in the Mid-West and North-East; Brandy's management had, however, been contemplating a merger with Danny for some time. They believed that better management and inventory control in Danny's business, as well as closing of 15 Danny's marginal stores, could result in eliminating 450 employees and in cost savings worth $10 million per annum in perpetuity. Brandy's offer of one Brandy's share (trading at $10 on the day of the offer) for every Danny share stunned the Markets when it was announced at 5 PM on December 31, 2002. Brandy's plans to issue 15 million new shares to replace the Danny's 15 million shares. Danny's CEO and Brandy's CEO met on the evening of Jan.2. During that meeting they agreed to a "small" addition: The deal will be consummated on 1/ 02/04 [i.e., in one year]; at that time, "every stockholder of Danny will have an option to exchange his Danny's share for one share of Brandy's or to get $10 in cash". With this addition both CEOs agreed to merge their firms on 1/ 02/04.

DATA

Danny's Balance Sheet on the 12/31/2002[Book Values].

Liabilities

Bank debt $ 0

8% bond due on 12/31/2015 1, $ 15 million

Stockholders equity 2,3 $ 30 million

Total liabilities $ 45 million

Assets

Cash $ 10 million

Fixed assets $ 35 million

Total assets $ 45 million

Notes: 1. The yield to maturity on Danny's debt (for all maturities) currently is 8 percent. 2. Danny's has 15 million shares outstanding, with market price of $5 a share. 3. Danny's equity beta is estimated at 1.25, the market risk premium is 8 percent, and the Treasury bill rate is 4 percent.

Brandy's Balance Sheet on the 12/31/2002 [Book Values].

Liabilities

Bank debt $ 0

10% bond due on 12/31/2012 1, $ 500 million

Stockholders equity 2,3 $ 50 million

Total liabilities $ 550 million

Assets

Cash $ 50 million

Fixed assets $ 500 million

Total assets $ 550 million

Notes: 1. The yield to maturity on Brandy's debt (for all maturities) currently is 10 percent. 2. Brandy's has 50 million shares outstanding, with market price of $10 a share. 3. Brandy's equity beta is estimated at 1.5, the market risk premium is 8 percent, and the Treasury bill rate is 4 percent

Q 1.1 Calculate the market-required rate of return on Danny's and on Brandy's equity and the WACC for the two firms.

Q 1.2 Use the above data to calculate the capitalized value of future savings due to "better management and inventory control in Danny's business as well as closing of 15 Danny's marginal stores". [Hint: think what discount rate should you use. If you cannot choose, assume the discount rate to be 12.5%].

Q.1.3 Present the Balance Sheets of Danny's and Brandy's in market values. Calculate the D E/ for each firm and compare their capital structures.

Q.1.4 Calculate the Market valuation of the two firms on 12/31/02. Explain why Brandy's stock beta is higher than Danny's. Then comment on following statements: 1."Danny could increase its value if it would borrow more " 2."Danny's relatively small debt burden was a reason for its take-over"".

Q.1 .5 Brandy's management plans to raise an additional $100 MM debt after acquisition of Danny goes through. Why? Estimate the expected benefits from this move.

Q.1.6 What kind of option was given to Danny's shareholders by agreement that "every stockholder of Danny will have to exchange her Danny share on 1/02/04 for one share of Brandy's or to get $10 in cash"? Why was there a need to give this option? What was the value of this option on 1/02/03? Who pays for this option? Elaborate Given: On 1/02/04 Danny will become part of Brandy's. On that day Brandy's shares will trade at one of the two values only: $11 or $8