Problem 22-06 Merger Valuation with Change in Capital Structure

VolWorld Communications Inc., a large telecommunications company, is evaluating the possible acquisition of Bulldog Cable Company (BCC), a regional cable company. VolWorld's analysts project the following post-merger data for BCC (in thousands of dollars, with a year end of December 31):

	2016	2017	2018	2019	2020	2021
Net sales		$450.0	$518.0	$ 555.0	$ 600.0	$ 643.0
Selling and administrative expense		45.0	53.0	60.0	68.0	73.0
Interest		40.0	45.0	47.0	52.0	54.0
Total net operating capital	800.0	850.0	930.0	1,005.0	1,075.0	1,150.0
Tax rate after merger: 35%
Cost of goods sold as a percent of sales: 50%
BCC's pre-merger beta: 1.10
Risk-free rate: 3%
Market risk premium: 6%
Terminal growth rate of free cash flows: 2%

If the acquisition is made, it will occur on January 1, 2017. All cash flows shown in the income statements are assumed to occur at the end of the year. BCC currently has a capital structure of 40% debt, which costs 6.00%, but over the next 4 years VolWorld would increase that to 50%, and the target capital structure would be reached by the start of 2021. BCC, if independent, would pay taxes at 30%, but its income would be taxed at 35% if it were consolidated. BCC's current market-determined beta is 1.10. The cost of goods sold is expected to be 50% of sales.

HINT: Keep all decimal points as you work through the problems.

A. What is the unlevered cost of equity for BCC? Do not round intermediate calculations. Round your answer to two decimal places. _______%

B. What are the free cash flows and interest tax shields for the first 5 years? Do not round intermediate calculations. Enter your answers in thousands. For example, an answer of $1.2 thousand should be entered as 1.2, not 1,200. Round your answers to two decimal places.

	2017	2018	2019	2020	2021
The free cash flows	$	$	$	$	$
The interest tax shields	$	$	$	$	$

C. What is BCC's horizon value of interest tax shields and unlevered horizon value? Do not round intermediate calculations. Enter your answers in thousands. For example, an answer of $1.2 thousand should be entered as 1.2, not 1,200. Round your answers to two decimal places.

Horizon value of interest tax shields	$ _____thousand
Unlevered horizon value	$ _____thousand

D. What is the value of BCC's equity to VolWorld's shareholders if BCC has $200,000 in debt outstanding now? Do not round intermediate calculations. Enter your answer in thousands. For example, an answer of $1.2 thousand should be entered as 1.2, not 1,200. Round your answer to two decimal places.

$ ____thousand

E. Not Needed