Reference no: EM13334873

Assume the firm, called XYZ, is acquired for $220 (the price for the assets = new invested capital) by a private equity firm. The private equity firm issues substantial debt to buy the firm, which leads to a high cost of equity and debt; although, it hopes to improve the firm and earn a high ROE and return on capital to compensate for this added risk.

Values of firm XYZ before acquisition

$100 Sales

$18 EBIT (18% of sales)

$4 Interest (4% interest rate on debt)

$14 EBT

40% Tax rate

$8.4 Net income

$200 Assets = invested capital

$100 Debt

$100 Equity

8.40% ROE (net income / equity)

5.40% ROIC (NOPAT / invested capital)

8.00% Cost of equity

2.40% After-tax cost of debt

5.20% WACC (using book values)

0.20% EVA (i.e., ROIC - WACC)

To compute the new WACC:

The old equity is gone since the firm is purchased. To fund the purchase, the private equity firm assumes all existing $100 debt at the current 4% interest rate, borrows $100 in new debt with a 12% interest rate, and contributes $20 in equity. The cost of this contributed equity is 20%. The new firm has a 40% tax rate.

Additional information to compute the new ROE and ROIC:

Following the acquisition, EBIT rises from 20% of sales from 18% of sales and sales rise to $105 as the private equity firm improves operations, and the tax rate is unchanged.

Note 1: The first question is very similar to the problem discussed in class.

Note 2: You should use the beginning value of equity, debt, and assets (invested capital) immediately after the acquisition for the denominator in the new ROE and ROIC calculations.

1. What is the new ROE?

a) 8.70%

b) 12.00%

c) 14.00%

d) 15.00%

e) 44.70%

2. What is the new WACC?

a) 4.00%

b) 6.18%

c) 8.36%

d) 9.09%

e) 9.42%

3. If the private equity firm uses EVA (i.e., ROIC - WACC) as a criteria for determining whether to make acquisitions, should the private equity firm acquire XYZ firm?