Reference no: EM132498668

Point 1: Ronson Inc., a technology company, is evaluating the possible acquisition of Blake equipment company. If the acquisition is made, it will occur on January 1, 2009. All cash flows shown in the income statements are assumed to occur at the end of the year. Blake currently has a capital structure of 40% debt, but Ronson would increase that to 50% if the acquisition were made.

Point 2: Blake, if independent, would pay taxes at 20%, but its income would be taxed at 35%, if it were consolidated. Blake's current market-determined beta is 1.40, and its investment bankers think that its beta would rise to 1.50 if the debt ratio were increased to 50%. The cost of goods sold is expected to be 65% of sales, but it could vary somewhat. Depreciation-generated funds would be used to replace worn-out equipment, so they would not be available to Ronson's shareholders. The risk-free rate is 8%, and the market risk premium is 4%.

Questions:

Question 1. What is the appropriate discount rate for valuing the acquisition?

Question 2. What is the terminal value?

Question 3. What is the value of Blake to Ronson?

Question 4. Suppose Blake has 120,000 shares outstanding. What is the maximum per share price Ronson should offer for Blake?

• Ronson management project the following post-merger financial data (thousands of dollars)

                                                                  2009                   2010                   2011                   2012

Net sales                                       $450                 $518                    $555                $600

Selling and Administrative expenses    $45                    $53                     $60                    $68

Interest                                         $18                     $21                      $24                     $27

Tax rate after merger 35%

Cost of goods sold as a % of sales 65%

Beta after merger 1.5

Risk-free rate 8%

Market-risk premium 4%

Terminal growth rate of cash flow available to Madison 7%

                                                  2009                 2010              2011               2012

Sales                                  $450.0           $518               $555            $600

Cost of Goods Sold (65%) 292.5 336.7

Gross Profit 157.5 181.3

Selling/admin costs 45 53

EBIT 112.5 128.3

Interest 18 21

EBT 94.5 107.3

Taxes (35%) 33.1 37.6

Net Income / Cash Flow 61.4 69.7

• In this scenario we state that net income and net cash flow are equal. This assumption arises from the fact that depreciation-generated funds would be used to replace worn-out equipment, and would be available to shareholders.

Question 1: To calculate the terminal value, we must determine the net cash flow for 2013. This is derived from the 2012 new cash flow at the terminal growth rate of cash flows. From this point, we derive terminal value from the basic DCF framework.