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Computing the Maximum Price to Pay for a Merger Candidate

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(Cash for Stock Merger) This problem requires that you integrate the material learned in prior chapters. You have been given the job of evaluating the following merger candidate. You have collected the following cash flow estimates for the acquisition candidate for the proposed merger (in millions):
Year 1 2 3 4 5__
Cash flows now for the target 60 80 100 125 150
Additional cash flows (synergy) 40 70 100 125 150
Total cash flows from target (after merger) 100 150 200 250 300

Risk free rate of return 4%
Beta for this project (the company after merging) 1.47
Market risk premium 5%
Pre-tax cost of debt 8%
Marginal after tax rate 25%
Number of shares outstanding for the target company (millions) 10
Current market price per share for the target company $51
Percentage of the acquisition financed with debt 40%
Percentage of the acquisition financed with common equity 60%

What is the after tax cost of debt for this merger (as we did in chapter 16)?

What is the after tax cost of common equity for this merger (as we did in chapter 16)?

What is the weighted average cost of capital for this acquisition candidate (as we did in chapter 16)?

Please run a net present value using the WACC calculated above with the total cash flows from the target (given above) to determine the maximum price per share you are willing to pay for this target candidate?

Based what you calculated and the current market price, would you pursue this candidate?

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Solution Summary

This solution illustrates how to compute the after-tax cost of debt, after-tax cost of equity, and weighted-average cost of capital to buy shares in a merger candidate, how to compute the net present value of the candidate's expected cash flows, how to compute the maximum price to pay for the candidate, and how to determine whether to pursue the merger.

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1. Possible net present values and associated probabilities for a new investment are as follows:
NPV -1020 -800 80 450 550 800
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2. You have been given the job of evaluating the following merger candidate. You have collected the following cash flow for the acquisition candidate for the proposed merger (in millions):
Year 1 2 3 4 5
Cash flows now 80 85 105 145 180
Additional cash flows with merger 40 90 100 125 150
Total cash flows with merger 120 175 205 270 330

Risk free rate of return 3.5%
Beta for this project (the company after merging) 1.6
Market risk premium 5%
Pre-tax cost of debt 7.5%
Marginal tax rate 30%
Number of shares outstanding for the target company (millions) 55
Current market price per share for the target company $60
Percentage of the acquisition financed with debt 50%
Percentage of the acquisition financed with common equity 50%

What is the after tax cost of debt?

What is the after tax cost of common equity

What is the weighted average cost of capital for this acquisition candidate?

What is the maximum price per share you are willing to pay for this candidate?

Based on the numbers above, would you pursue this candidate?

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