Mike's Home Repair Company, a regional hardware chain, which specializes in do-it-yourself materials and equipment rentals, is cash rich because of several consecutive good years. One of the alternatives uses for the excess funds is an acquisition. Jane Fonda, Mikes treasurer, and your boss has been asked to place a value on a potential target, Jake's Jewels (JJ) a chain which operates in several adjacent states, and she has enlisted your help. The table -1 below indicates Fondas estimates of JJs earnings potential if it came under Wallaces management (in millions of dollars). The interest expense listed here includes the interest (1) on JJs existing debt, which is $55 million at a rate of 9 percent, and (2) on new debt expected to be issued over time to help finance expansion within the new JJ division, the code name given to the target firm. If acquired, JJ will face a 30 percent tax rate.

Table 1

2021 2022 2023 2024 2025 2026 Net sales 60.00 90.00 112.50 129.38 142.31 Cost of goods sold (60%) 60% 36.00 54.00 67.50 77.63 85.39 Selling/administrative expense 7.50% 4.50 6.75 8.44 9.00 11.00 Interest expense 5.00 6.50 6.50 7.00 8.16 Total Net Operating Capital 150.00 150.00 157.50 163.50 168.50 173.50

Table 2 risk free rate 4% market risk premium 6% pre-merger beta 1.3 pre-merger % debt 20% pre-merger debt in millions) $55.00 pre-merger debt R d 9% Tax rate 30%

Security analysts estimate JJs beta to be 1.3. The acquisition would not change Jakes capital structure, which is 20 percent debt. Fonda realizes that JJs business plan also requires certain levels of operating capital, and that the annual investment could be significant. Fonda estimates the risk-free rate to be 4 percent and the market risk premium to be 6 percent. She also estimates that free cash flows after 2026 will grow at a constant rate of 5 percent. Mikes management is new to the merger game, so Fonda has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Fonda has developed the following questions, which you must answer and then defend to Mikes board. 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 below-replacement cost,

5. synergy, and 6. globalization. Use the data developed in the table 1 to construct the LL divisions free cash flows for 2022 through 2026. Answer the following questions: 1. Assume that JJ; 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 Mikes make an offer for JJ? If so, how much should it offer per share? 2. There has been considerable research undertaken to determine whether mergers really create value, and, if so, how this value is shared between the parties involved. What are the results of this research? 3. What merger-related activities are undertaken by investment bankers? 4. What is a leveraged buyout (LBO)? What are some of the advantages and disadvantages of going private?