Marston Marble Corporation is considering a merger with the Conroy Concrete Company.
Conroy is a publicly traded company, and its current beta is 1.30. Conroy has been barely profitable, so it has paid an average of only 20 percent in taxes during the last several years. In addition, it uses little debt, having a target debt ratio of just 25 percent, with the cost of debt 9 percent. If the acquisition were made, Marston would operate Conroy as a separate wholly owned subsidiary. Marston would pay taxes on a consolidated basis, and the tax rate would therefore increase to 35 percent. Marston would also increase the debt capitalization in the Conroy subsidiary to 40 percent of assets, and pay 9.5 percent on the debt. Marston's acquisition department estimates that Conroy, if acquired, would generate the following free cash flows and interest expenses (in millions of dollars):
Year Free Cash Flows Interest Expense
1 $1.30 $1.20
2 1.50 1.70
3 1.75 2.80
4 2.00 2.10
5 and beyond Constant growth at 6%
These cash flows include all acquisition effects. Marston's cost of equity is 14 percent, its beta is 1.0, and it cost of debt is 10 percent. The risk free rate is 6 percent and the market risk premium is 4.5%.
a. Whit discount rate should be used to discount the estimated cash flows and tax shields in
Years 1-5? To discount the horizon value?
b. What is the dollar value of Conroy's operations? If Conroy has $10 million in debt outstanding, how
much would Marston be willing to pay for Conroy?
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The solution shows how to calculate and estimate a discounted cash flow and the purchase price in the context of a merger.