Madison Inc; a technology company, is evaluating the possible acquisition of Peterson equipment company. If the acquisition is made, it will occur on January 1, 2009. All cash flows shown in the income
statements are assumed to occur at the end of the year. Peterson currently has a capital structure of 40%
debt, but Madison would increase that to 50% if the acquisition were made. Peterson, if independent,
would pay taxes at 20%, but its income would be taxed at 35% if it were consolidated. Petersons current
market-determined beta is 1.40, and its investment bankers think that its beta would rise to 1.50 if the
debt ratio were increased to 50%. The cost of goods sold is expected to be 65% of sales, but it could vary
somewhat. Depreciation-generated funds would be used to replace worn-out equipment, so they would not
be available to Madisons shareholders. The risk-free rate is 8%, and the market risk premium is
4%.

.

a. What is the appropriate discount rate for valuing the acquisition?

b. What is the terminal value?

c. What is the value of Peterson to Madison?

d. Suppose, Peterson has 120,000 shares outstanding. What is the maximum per share price Madison should
offer for Peterson?

Madison management project the following post merger financial data (thousands of dollars

	2009	2010	2011	2012
Net sales	$450	$518	$555	$600
Selling and admin expense	45	53	60	68
Interest	18	21	24	27
Tax rate after merger	35%
Cost of goods sold as a % of sales	65%
Beta after merger	1.5
Risk-free rate	8%
Market risk premium	4%
Terminal growth rate of cash flow	7%
available to Madison

	2009	2010	2011	2012
Sales	$450.0	$518.0	$555.0	$600.0
Cost of Goods Sold (65%)	292.5	336.7
Gross Profit	157.5	181.3
Selling/admin. costs	45.0	53.0
EBIT	112.5	128.3
Interest	18.0	21.0
EBT	94.5	107.3
Taxes(35%)	33.1	37.6
Net Income/Cash Flow	$61.4	$69.7

In the scenario, we state that net income and net cash flow are equal. This assumption arises from the fact that depreciation-generated funds would be used to replace worn-out equipment, and would not be available to shareholders.

To calculate the terminal value, we must determine the net cash flow for 2013. This is derived as the 2012 net cash flow expanded at the terminal growth rate of cash flows. From this point, we can derive terminal value from the basic DCF framework.

Please show how you got the answer by step by step.