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ABC Company, a regional hardware chain that specializes in 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. Zoha, ABCs treasurer and your boss, has been asked to place a value on a potential target, YL, a chain that operates in several provinces, and he has enlisted your help.

The table below indicates Zohas estimates of YLs earnings potential if it came under ABCs management (in millions of dollars). The interest expense listed here includes the interest (1) on YLs existing debt, which is $55 million at a rate of 9%, and (2) on new debt expected to be issued over time to help finance expansion within the new L division. If acquired, YL will face a 40% tax rate.

Security analysts estimate YLs beta to be 1.3. The acquisition would not change YLs capital structure, which is 20% debt. Zoha realizes that YLs business plan also requires certain levels of operating capital and that the annual investment could be significant. The required levels of total net operating capital are listed below.

Zoha estimates the risk-free rate to be 7% and the market risk premium to be 4%. He also estimates that free cash flows after 2020 will grow at a constant rate of 6%. Following are projections for sales and other items.

ABCs management is new to the merger game, so Zoha has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Zoha has developed the following questions, which you must answer and then defend to ABCs board.

Questions (All about concepts, not much calculation):

1, Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax considerations, (2) risk reduction, (3) control, (4) purchase of assets at below-replacement cost, (5) synergy, and (6) globalization. In general, which of the reasons are economically justifiable? Which are not? Which fit the situation at hand? Explain.

2, The estimated value of YLs cash flows beyond 2020 is $384.232 million. Does this number indicate YLs value to ABCs shareholders? Suppose another firm were evaluating YL as an acquisition candidate. Would that company obtain the same value? Explain.

3, YL has 20 million shares outstanding. These shares are traded several weeks ago at a price of $11 per share. The best offer Q can make is for 384.234 / 20 = $19.21 per share. Should ABCs make an offer for YL or not?

4,There has been considerable research undertaken to determine whether mergers really create value and, if so, how this value is shared between the parties involved. What are the results of this research?

2015 2016 201720182019 2020 $60.00 $90.00 $112.50 $127.50 $139.70 36.0054.00 67.50 76.50 83.80 4.50 6.007.509.00 11.00 5.006.50 6.50 7.008.16 Total net operating capital 150.00 150.00 157.50 163.50 168.00 173.0 55.55 72.22 72.22 77.78 90.6796.1 Net sales Cost of goods sold (60%) Selling/administrative expense Interest expense Debt

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