Hagers Home Repair Company, a regional hardware chain that specializes in do it yourself 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, Hagers treasurer and your boss, has been asked to place a value on a potential target, Lyons Lighting (LL), a chain that operates in several adjacent states, and he has enlisted your help.

The table below indicates Zonas estimates of LLs earnings potential if it came under Hagers management (in millions of dollars). The interest expense listed here includes the interest: (1) on LLs existing debt, which is $63 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 35% tax rate.

Security analysts estimate LLs beta. The acquisition would not change Lyons capital structure, which is 22% debt. Zona realizes that Lyons Lightings 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 in the table.

Zona estimates the risk-free rate and the market risk premium. He also estimates that free cash flows after 2020 will grow at a constant rate. Following are projections for sales and other items.

	Group 1	Group 2	Group 3	Group 4	Group 5
LLs beta	1.35	1.25	1.30	1.45	1.5
Risk Free rate	7.2%	7.5%	7.8%	6.3%	6.7%
Mkt risk premium	4.75%	5.2%	5.47%	4.33%	4.6%
Free cash flow growth rate	6%	5.2%	4%	3.78%	3.69%

	2015	2016	2017	2018	2019	2020
Net Sales		$60.00	$90.00	$112.50	$127.50	$139.70
Cost of Goods Sold		36.00	54.00	67.50	76.50	83.80
Selling /Administrative Expense		4.80	6.10	7.60	9.20	11.30
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

Hagers 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 Hagers board.

Briefly describe the differences between a hostile merger and a friendly merger.

Use the data developed in the table to construct the L divisions free cash flows for 2016 through 2020. Why are we identifying interest expense separately when it is not normally included in calculating free cash flows or in a capital budgeting cash flow analysis? Why is investment in net operating capital included when calculating the free cash flow?

Conceptually, what is the appropriate discount rate to apply to the cash flows developed in part c? What is your actual estimate of this discount rate?

What is the estimated horizon, or continuing, value of the acquisition; that is, what is the estimated value of the L divisions cash flows beyond 2020? What is LLs value to Hagers shareholders? Suppose another firm were evaluating LL as an acquisition candidate. Would it obtain the same value? Explain.

Assume that LL has 22 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 Hagers make an offer for Lyons Lighting? If so, how much should it offer per share?

How would the analysis be different if Hagers intended to recapitalize LL with 40% debt costing 10% at the end of 4 years? This amounts to $221.6 million in debt as of the end of 2019.

What are the major types of divestitures? What motivates firms to divest assets?