Question
Firm A (the acquiring firm) is in the similar business as Firm T (the acquired or target firm) and is considering acquiring Firm T. Firm
Firm A (the acquiring firm) is in the similar business as Firm T (the acquired or target firm) and is considering acquiring Firm T. Firm A expects to generate annual before-tax cost savings from the acquisition of $80 million by the end of year 5. The cost savings benefit would be $20 million in year 2, increase by $20 million per year until it reaches $80 million in year 5, and remain at $80 million thereafter. Firm A also expects that, following the merger, it would incur before-tax costs associated with integrating the two companies for a total of $140 million over the first two years (i.e., $70 million for each year). Below is the information for Firm T. Year 0 is the year of valuation.
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Firm T ($ millions) ______________________________________________________________
Year 0 1E 2E 3E 4E 5E 6E _____________________________________________________________________________________
Pre-tax sales Pre-tax operating income Pre-tax cost savings Pre-tax cost of integrating businesses Depreciation expense Capital expenditures _____________________________________________________________________________________
Firm Ts annual net working capital is 12 percent of sales for the year. Tax rate is 25%. The firms pre-tax cost of debt is 7 percent per year. The annual risk free rate of return is 5 percent and the annual market rate of return is 11 percent. The company has a debt to equity ratio of 0.40 and a levered equity beta of 1.5. Assume that free cash flows grow at a constant annual growth rate of 5% forever after year 6. Find the value of the firm with synergies based on the free cash flow valuation model.
Notes:
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Sales estimated using 8% growth through year 5 and 5% growth beyond year 5.
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Pre-tax operating income estimated as 10% of sales. The pre-tax operating income is the
earnings before interest and taxes (EBIT) defined as Sales Fixed costs Variable costs Depreciation expense.
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