Reference no: EM131050163
Hank's Fine Fix-its, a regional hardware chain, which specializes in "do-it-yourself" 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. Doug Zona, Hank's treasurer and your boss, has been asked to place a value on a potential target, Larry's, a small chain which operates in an adjacent state, and he has enlisted your help.
The table below indicates Zona's estimates of Larry's earnings potential if it came under Hank's management (in millions of dollars). The interest expense listed here includes the interest (1) on Larry's 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," the code name given to the target firm. If acquired, Larry's lighting will face a 40% tax rate.
Security analysts estimate that Larry's beta is 1.3. The acquisition would not change Larry's capital structure. Zona realizes that Larry's also generates depreciation cash flows, all of which must be reinvested in the division to replace worn-out equipment. The net retentions in the table below are required reinvestment in addition to these depreciation cash flows. Zona estimates the risk-free rate to be 9 percent and the market risk premium to be 4 percent. He also estimates that free cash flows after 2014 will grow at a constant rate of 6 percent. Following are projections for sales and other items.
2011 2012 2013 2014
Net sales $60.0 $90.0 $112.5 $127.5
Cost of goods sold (60%) 36.0 54.0 67.5 76.5
Selling/administrative expense 4.5 6.0 7.5 9.0
Interest expense 5.0 6.5 6.5 7.0
Required net retentions 0.0 7.5 6.0 4.5
Hank's management is new to the merger game, so Zona has asked for your help. What is the appropriate discount rate to apply to the cash flows? What is your actual estimate of this discount rate? Assume that Larry's has 20 million shares outstanding. These shares are traded relatively infrequently, but the last trade, made several weeks ago, was at a price of $7.50 per share. Use that information with the $55 million in debt to figure the capital structure and weights for cost of capital estimate. Should Hank's make an offer for Larry's? If so, how much should it offer per share?
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