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 December 31 year-end):

If the acquisition is made, it will occur on January 1, 2005. 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 percent debt, which costs 10 percent, but VolWorld would increase that to 50 percent, also costing 10 percent, if the acquisition were made. BCC, if independent, would pay taxes at 20 percent, but its income would be taxed at 35 percent if it were consolidated. BCC's current market-determined beta is 1.40. The cost of goods sold is expected to be 65 percent of sales. Required retentions are net of depreciation'that is, they are gross retentions minus depreciation charged.

a. What is the appropriate discount rate for each of the cash flows when valuing the acquisition?

b. What are the free cash flows and interest tax shields for the first 4 years?

c. What is BCC's horizon value?

d. What is the value of BCC's equity to VolWorld's shareholders if BCC has $300,000 in debt outstanding now?

Transcribed Image Text:

2006 2008 2005 2007 Net sales $450 $518 $555 $600 Selling and administrative expense 45 53 60 68 Interest 40 45 47 52 50 Net required retentions 80 75 70 Tax rate after merger Cost of goods sold as a percent of sales 35% 65% BCC's pre-merger beta 1.40 Risk-free rate 6% Market risk premium 4% Terminal growth rate of free cash flows