Smittys 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. Linda Wade, Smittys treasurer, and your boss, has been asked to place a value on a potential target, Hills Hardware, a small chain that operates in an adjacent state, and she has enlisted your help.

Table below indicates Wades estimates of Hills earnings potential if it comes under Smittys management (in millions of dollars). The interest expense listed here includes the interest (1) on Hills existing debt, (2) on new debt that Smittys would issue to help finance the acquisition, and (3) on new debt expected to be issued over time to help finance expansion within the new H division, the code name given to the target firm. The retentions represent earnings that will be reinvested within the H division to help finance its growth.

2021 2022 2023 2024

Net sales $60.0 $90.0 $112.5 $127.5

Cost of goods sold (60%) 36.0 54.0 67.5 76.5

Selling/administrative expense 4.6 6.0 7.4 9.0

Interest expense 3.0 4.4 4.4 6.0

Retentions 0.0 7.5 6.0 4.5

Hills Hardware currently uses 40% debt financing, and it pays federal-plus-state taxes at a 20% rate. Security analysts estimate Hills beta to be 1.25. If the acquisition were to take place, Smittys would increase Hills debt ratio to 50%, which would increase Hills beta to 1.43. Further, because Smittys is highly profitable, taxes on the consolidated firm would be 25%. Wade realizes that Hills Hardware also generates depreciation cash flows, but she believes that these funds would have to be reinvested within the division to replace worn-out equipment.

Wade estimates the risk-free rate to be 9% and the market risk premium to be 4%. She also estimates that cash flows after 2024 will grow at a constant rate of 6%. Smittys management is new to the merger game, so Wade has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Wade has developed the following questions, which you must answer and then defend to Smittys board.

What is Hills value to Smittys?