Hagers Home Repair Company, a regional hardware chain, which specializes in do-it-yourself materials and equipment rentals, is considering an acquisition of Lyon Lighting (LL). Doug Zona, Hagers treasurer and your boss, has been asked to place a value on the target and he has enlisted your help. LL has 20 million shares of stock trading at $12 per share. Security analysts estimate LLs beta to be 1.25. The risk-free rate is 5.5% and the market risk premium is 4%. LL's capital structure is 20% financed with debt at an 8% interest rate; any additional debt due to the acquisition also will have an 8% rate. LL has a 25% federal-plus-state tax rate which will not change due to the acquisition.

The following data incorporate expected synergies and required levels of total net operating capital for LL should Hager's complete the acquisition. The forecasted interest expense includes the combined interest on LLs existing debt and on new debt. After 2024, all items are expected to grow at a constant 6% rate.

2019 2020 2021 2022 2023 2024

Net sales $150 $170 $186 $200 $212

Cost of goods sold $116 $128 $135 $148 $160

SGA $22 $26 $27 $28 $32

Total net operating capital $64 $75 $85 $93 $100 $106

Debt^a $30 $50 $52 $52 $53 $54

Note: ^aDebt is added on the first day of the year, so the 2019 debt is LL's debt prior to the acquisition.

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.

a. Several reasons have been proposed to justify mergers. Among the more prominent are (1) synergy, (2) tax considerations, (3) breakup value, (4) risk reduction through diversification, (4) purchase of assets at below-replacement cost, and (5) managerial incentives. In general, which of the reasons are economically justifiable? Which are not?

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

c. 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?