Wallace’s Home Repair Company Wallace’s Home Repair Company, a regional hardware chain, which specializes in “do-it-yourself” materials and equipment rentals, is cash rich because of several...

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Wallace’s Home Repair Company Wallace’s Home Repair Company, 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 alternatives uses for the excess funds is an acquisition. Julie Dona, Wallace’s treasurer, and your boss has been asked to place a value on a potential target, Lyons’ Lighting (LL) a chain which operates in several adjacent states, and she has enlisted your help. The table -1 below indicates Dona’s estimates of LL’s earnings potential if it came under Wallace’s management (in millions of dollars). The interest expense listed here includes the interest (1) on LL’s existing debt, which is $55 million at a rate of 9 percent, and (2) on new debt expected to be issued over time to help finance expansion within the new “LL division,” the code name given to the target firm. If acquired, LL will face a 30 percent tax rate. Table 1 2021 2022 2023 2024 2025 2026 Net sales   60.00 90.00 112.50 129.38 142.31 Cost of goods sold (60%) 60% 36.00 54.00 67.50 77.63 85.39 Selling/administrative expense 7.50% 4.50 6.75 8.44 9.00 11.00 Interest expense   5.00 6.50 6.50 7.00 8.16 Total Net Operating Capital 150.00 150.00 157.50 163.50 168.50 173.50 Table 2   risk free rate 4% market risk premium 6% pre-merger beta 1.3 pre-merger % debt 20% pre-merger debt 9in millions) $55.00 pre-merger debt Rd 9% Tax rate 30% Security analysts estimate LL’s beta to be 1.3. The acquisition would not change Lyons’ capital structure, which is 20 percent debt. Dona realizes that Lyons’ Lighting’s business plan also requires certain levels of operating capital, and that the annual investment could be significant. Dona estimates the risk-free rate to be 4 percent and the market risk premium to be 6 percent. She also estimates that free cash flows after 2026 will grow at a constant rate of 5 percent. Wallace’s management is new to the merger game, so Dona has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Dona has developed the following questions, which you must answer and then defend to Wallace’s board. 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. Briefly describe the differences between a hostile merger and a friendly merger. What are the steps in valuing a merger? Use the data developed in the table 1 to construct the LL division’s free cash flows for 2022 through 2026. Conceptually, what is the appropriate discount rate to apply to the cash flows? What is your actual estimate of this discount rate? What is the estimated horizon, or continuing, value of the acquisition; that is, what is the estimated value of the LL division's unlevered cash flows and tax shields beyond 2026? What is Lyons' value to Wallace’s shareholders? Suppose another firm were evaluating Lyons' as an acquisition candidate. Would they obtain the same value? Explain. Assume that Lyons' has 20 million shares outstanding. These shares are traded relatively infrequently, but the last trade, made several weeks ago, was at a price of $11 per share. Should Wallace’s make an offer for Lyons'? If so, how much should it offer per share? 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? What method is used to account for mergers? What merger-related activities are undertaken by investment bankers? What is a leveraged buyout (LBO)? What are some of the advantages and disadvantages of going private? What are the major types of divestitures? What motivates firms to divest assets? What are holding companies? What are their advantages and disadvantages?
Oct 21, 2021
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