Hager's Home Repair Company, a regional hardware chain that specializes in "do-ityourself"

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. Doug Zona, Hager's

treasurer and your boss, has been asked to place a value on a potential target, Lyons Lighting

(LL), a chain that operates in several provinces and he has enlisted your help.

The table below indicates Zona's estimates of LL' s earnings potential if it came under

Hager's management (in millions of dollars). The interest expense listed here includes the

interest (1) on LL's existing debt, which is $55 million at a rate of 9%, and (2) on new debt

expected to be issued over time to help finance expansion within the new "L division," the

code name given to the target firm. If acquired, LL will face a 40% tax rate.

Security analysts estimate LL's beta to be 1.3. The acquisition would not change Lyons's

capital structure, which is 20% debt. Zona realizes that Lyons Lighting's business plan also

requires certain levels of operating capital and that the annual investment could be significant.

The required levels of total net operating capital are listed below.

Zona estimates the risk-free rate to be 7% and the market risk premium to be 4%. He

also estimates that free cash flows after 2020 will grow at a constant rate of 6%. Following are

projections for sales and other items.

2015 2016 2017 2018 2019 2020

Net sales $60.00 $90.00 $112.50 $127.50 $139.70

Cost of goods sold (60%) 36.00 54.00 67.50 76.50 83.80

Selling/ administrative expense 4.50 6.00 7.50 9.00 11.00

Interest expense 5.00 6.50 6.50 7.00 8.16

Total net operating capital $150.00 150.00 157.50 163.50 168.00 173.00

Debt 55.55 72.22 72.22 77.78 90.67 96.1

Hager's management is new to the merger game, so Zona has been asked to answer

some basic questions about mergers as well as to perform the merger analysis. To structure

the task, Zona has developed the following questions, which you must answer and then

defend to Hager'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 belowreplacement

cost, (5) synergy, and (6) globalization. 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. What are the steps in valuing a merger?

D. Use the data developed in the table to construct LL's free cash flows to equity for 2016 through 2020. Why are investment in net operating capital and changes to debt included

when calculating free cash flow to equity?

E.Conceptually, what is the appropriate discount rate to apply to the cash flows developed

in part d? What is your actual estimate of this discount rate?

F.What is the estimated horizon, or continuing, value of the acquisition; that is, what is the

estimated value of LL' s cash flows beyond 2020? What is LL' s value to Hager's shareholders?

Suppose another firm were evaluating LL as an acquisition candidate. Would

that company obtain the same value? Explain.

G.Assume that LL has 20 million shares outstanding. These shares are traded relatively

infrequently, but the last trade, made several weeks ago, was at a price of $11 per share.

Should Hager's make an offer for Lyons Lighting? If so, how much should it offer per

share?