1.

MERGERS & ACQUISITION

ST 2 - Moist Burgers, an international burger chain, is considering purchasing a smaller chain, Laya
Buns. Moist Burger's analysts project that the merger will result in incremental cash flows of $1.5
million in Year 1, $2 million in Year 2, $3 million in Year 3, and $5 million in Year 4. In addition, Laya's
Year 4 cash flows are expected to grow at a constant rate of 5% after Year 4. Assume that all cash flows
occur at the end of the year. The acquisition will be made immediately if it is undertaken. Laya Buns's
post-merger beta is estimated to be 1.5, and its postmerger tax rate would be 40%. The risk-free rate
is 6%, and the market risk premium is 4%. What is the value of Laya Buns to Moist Burgers?

21-2 Angry Ducks estimate that if it acquires Farmers' Ville, the year-end dividend will remain at
$2.00 a share, but synergies will enable the dividend to grow at a constant rate of 7% a year (instead
of the current 5%). Angry Ducks also plans to increase the debt ratio of what would be its Farmers'
Ville subsidiary-the effect of this would be to raise Farmers' Ville beta to 1.1. What is the per-share
value of Farmers' Ville to Angry Ducks? (ANS: P0=43.48)

21-4 Goldilocks Appliance Corporation is considering a merger with the Black-Wolf Vacuum
Company. Black-Wolf is a publicly traded company, and its current beta is 1.30. Black-Wolf has been
barely profitable, so it has paid an average of only 20% in taxes during the last several years. In
addition, it uses little debt, having a debt ratio of just 25%.

If the acquisition were made, Goldilocks would operate Black-Wolf as a separate, wholly-owned
subsidiary. Goldilocks would pay taxes on a consolidated basis, and the tax rate would therefore
increase to 35%. Goldilocks also would increase the debt capitalization in the Black-Wolf subsidiary
to 40% of assets, which would increase its beta to 1.47. Goldilocks’s acquisition department
estimates that Black-Wolf, if acquired, would produce the following cash flows to Goldilocks's
shareholders (in millions of dollars).

Year Cash Flows

1 1.30
2 1.50
3 1.75
4 2.00
5 and beyond Constant growth at 6%

These cash flows include all acquisition effects. Goldilocks's cost of equity is 14%, its beta is 1.0, and
its cost of debt is 10%. The risk-free rate is 8%.

a. What discount rate should be used to discount the estimated cash flows? (Hint: Use Goldilocks's
r, to determine the market risk premium.) (16.8%)
b. What is the dollar value of Black Wolf to Goldilocks? (V=14.93M)
c. Black-Wolf has 1.2 million common shares outstanding. What is the maximum price per share
that Goldilocks should offer for Black Wolf? If the tender offer is accepted at this price, what will
happen to Goldilocks's stock price? (12.44)

21-5 The Stanley Stationery Shoppe wants to acquire The Carlson Card Gallery for RM400,000.
Stanley expects the merger to provide incremental earnings of about RM64,000 a year for 10 years.
Ken Stanley has calculated the marginal cost of capital for this investment to be 10%. Conduct a
capital budgeting analysis for Stanley to determine whether he should purchase The Carlson Card
Gallery.
21-6 Merger Analysis

SingTel Corp, a large telecommunication company, is evaluating the possible acquisition of Pixable
Inc., a social photo aggregation service company. SingTel’s analysts project the following post-merger
data for Pixable (in thousand dollars):

If the acquisition is made, it will occur on January 1, 2013. All cash flows shown in the income
statements are assumed to occur at the end of the year. Pixable currently has a capital structure of
40% debt, but SingTel would increase that to 50% if the acquisition were made. Pixable, if independent,
would pay taxes at 20%; but its income would be taxed at 35% if it were consolidated. Pixable'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 SingTel's shareholders. The risk-free rate is 8%, and the market risk premium
is 4%.

a. What is the appropriate discount rate for valuing the acquisition?(14%)

b. What is the continuing value? (1,143.4)
c. What is the value of Pixable to Sing"Tel? (V=877.2)
2. COST OF CAPITAL
3. CASH FLOW ESTIMATION AND ANALYSIS RISK
4. Cost of Capital
ST 2 - You must analyze two projects, X and Y.
Each project costs $10,000, and the firm's WACC is 12%. The expected cash flows are as follows:

Years Project X Project Y

0 -10,000 -10,000
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500

a. Calculate each project's NV, IRR, MIRR, payback, and discounted payback.
b. Which project(s) should be accepted if they are independent?
c. Which project(s) should be accepted if they are mutually exclusive?
d. How might a change in the WACC produce a conflict between the NPV and IRR rankings of the
two projects? Would there be a conflict if WACC were 5%? (Hint: Plot the NPV profiles. The
crossover rate is 6.21875%.)
e. Why does the conflict exist?

12.1 NPV Project K costs $52,125, its expected cash inflows are $12,000 per year for 8 years, and its
WACC is 12%. What is the project's NPV?
12.2 IRR Refer to problem 12-1. What is the project's IRR?
12.3 MIRR Refer to problem 12-1. What is the project's MIRR?
12.4 PAYBACK PERIOD Refer to problem 12-1. What is the project's payback?
12.5 DISCOUNTED PAYBACK Refer to problem 12-1. What is the project's discounted payback?
12.6 NPV Your division is considering two projects with the following cash flows (in millions):

Years Project A Project B

0 -25 -20
1 5 10
2 10 9
3 17 6

a. What are the projects' NPVs assuming the WACC is 5%? 10%? 15%?
b. What are the projects' IRRs at each of these WACCs?
c. If the WACC was 5% and A and B were mutually exclusive, which project would you choose?
What if the WACC was 10%? 15%? (Hint:
The crossover rate is 7.81%.)
12.7 A firm with a 14% WACC is evaluating two projects for this year’s capital budgeting. After-tax cash
flow, including depreciation, are as follows :
a. Calculate the NPV, IRR, MIRR, payback, and discounted payback for each project.
b. Assuming the projects are independent, which one(s) would you recommend?
c. If the projects are mutually exclusive, which would you recommend?
d. Notice that the projects have same cash flow timing pattern, Why is there a conflict between
NPV and IRR?
12.8 CAPITAL BUDGETING CRITERIA: ETHIC BE CONSIDERATIONS A BE

A mining company is considering a new project. Because the mine has received a permit, the project
would be legal, but it would cause significant harm a nearby river. The firm could spend an additional
$10 million at Year 0 to mitigate the environmental problem, but it would not be required to do so.
Developing the mine (without mitigation) would cost $60 million, and the expected cash inflows would
be $20 million per year for 5 years. If the firm does invest in mitigation, the annual inflows would be
$21 mile The risk-adjusted WACC is 12%.

a. Calculate the NPV and IRR with and without mitigation.

b. How should the environmental effects be dealt with when this project is evaluated?
c. Should this project be undertaken? If so, should the firm do the mitigation?

12.9 CAPITAL BUDGETING CRITERIA: ETHICAL CONSIDERATIONS

An electric utility is considering a new power plant in northern Arizona. Power from the plant would
be sold in the Phoenix area, where it is badly needed. Because the firm has received a permit, the plant
would be legal; but it would cause some air pollution. The company could spend an additional $40
million at Year 0 to mitigate the environmental problem, but it would not be required to do so. The
plant without mitigation would cost $240 million, and the expected cash inflows would be $80 million
ye year for 5 years. If the firm does invest in mitigation, the annual inflows would be $84 million.
Unemployment in the area where the plant would be built is high, and the plant would provide about
350 good jobs. The risk-adjusted WACC is 17%.

a. Calculate the NPV and IRR with and without mitigation.

b. How should the environmental areas be dealt with when evaluating this project?

c. Should this project be undertaken? If so, should the firm do the mitigation? Why or why not?

12.10 A firm with WACC 10% is considering the following mutually exclusive projects:

Years Project A Project B

0 -400 -600
1 55 300
2 55 300
3 55 50
4 225 50
5 225 49
Which project you would recommend?

12. 11 Project S cost $15,000 and its expected cash flows would be $4500 per year for 5 years. Mutually
exclusive Project L costs $37,500, and its expected cash flow would be $11,000 per year for 5 years. If
both projects have a WACC of 14%, which project would you recommend? Explain.
12.12 A company is analyzing two mutually exclusive projects, S and L, with the following cash flows:

Years Project S Project L

0 -1,000 -1,000
1 900 0
2 250 250
3 10 400
4 10 800
The company’s wacc is 10%. what is the IRR of the better project? (Hint: the better project may or may
not be the one with the higher IRR)

12.13 A firm is considering two mutually exclusive projects, X and Y, with the following cash flows:

Years Project X Project

0 -1,000 -1,000
1 100 1,000
2 300 100
3 400 50
4 700 50
The projects are equally risky, and their WACC is 12%. What is the MIRR of the project that maximizes
shareholder value?

12.14 CHOOSING MANDATORY PROJECTS ON THE BASIS OF LEAST COST

Kim Inc. must install a new air conditioning unit in its main plant. Kim must install one or the other of
the units; otherwise, the highly profitable plant would have to shut down. Two units are available, HCC
and LCC (for high and low capital costs, respectively). HCC has a high capital cost but relatively low
operating costs, while LCC has a low capital cost but higher operating costs because it uses more
electricity. The costs of the units are shown here. Kim's WACC is 7%.
Years HCC LCC
0 -600,000 -100,000
1 50,000 175,000
2 50,000 175,000
3 50,000 175,000
4 50,000 175,000
5 50,000 175,000
a. Which unit would you recommend? Explain.
b. If Kim's controller wanted to know the IRRs of the two projects, what would you tell him?
c. If the WACC rose to 15% would this affect your recommendation? Explain your answer and
the reason this result occurred.
12.15 NPV PROFILES: TIMING DIFFERENCES
An oil-drilling company must choose between two mutually exclusive extraction projects, and each
costs $12 million. Under Plan A, all the oil would be extracted in 1 year, producing a cash flow at t=1
of $14.4 million. Under Plan B, cash flows would be $2.1 million per year for 20 years. The firm's WACC
is 12%
a. Construct NPV profiles for Plans A and B, identify each project’s IRR, and show the approximate
crossover rate.
b. Is it logical to assume that the firm would take on all available independent, average risk projects
with returns greater than 12%? If all available projects with returns greater than 12% have been
undertaken, does this mean that cash flows from past investments have an opportunity cost of
only 12% because all the company can do with these cash flows is to replace money that has a
cost of 12% Does this imply that the WACC is the correct reinvestment rate assumption for a
project's cash flows? Why or why not?

12.16 NPV PROFILES: SCALE DIFFERENCES

A company is considering two mutually exclusive expansion plans. Plan A requires a $40 million
expenditure on a large-scale integrated plant that would provide expected cash flows of $6.4 million
per year for 20 years. Plan B requires a $12 million expenditure to build a somewhat less efficient,
more labor-intensive plant with expected cash flows of $2.72 million per year for 20 years. The firm's
WACC is 10%.
a. Calculate each project's NPV and IRR.
b. Graph the NPV profiles for Plan A and Plan B and approximate the crossover rate.
c. Calculate the crossover rate where the two projects' NPVs are equal.
d. Why is NPV better than IRR for making capital budgeting decisions that add to shareholder
value?
12.17 A company has a 12% WACC and is considering two mutually exclusive investments (that cannot
be repeated) with the following cash flows:
Years Project A Project B
0 -300 -405
1 -387 134
2 -193 134
3 -100 134
4 600 134
5 600 134
6 850 134
7 180 0
a. What is each project's NPV?
b. What is each project's IRR?
c. What is each project's MIRR? (Hint: Consider Period 7 as the end of Project B's life.)
d. From your answers to parts a, b, and c, which project would be selected? If the WACC was
18%, which project would be selected?
e. Construct NPV profiles for Projects A and B.
f. Calculate the crossover rate where the two projects' NPVs are equal.
g. What is each project's MIRR at a WACC of 18%?
12.18 NPV AND IRR
A store has 5 years remaining on its lease in a mall. Rent is $2,000 per month, 60 payments remain,
and the next payment is due in 1 month. The mall's owner plans to sell the property in a year and
wants rent at that time to be high so that the property will appear more valuable. Therefore, the store
has been offered a "great deal" (owner's words) on a new 5-year lease. The new lease calls for no rent
for 9 months, then payments of $2,600 per month for the next 51 months. The lease cannot be broken,
and the store's WACC is 12% (or 1% per month).
a. Should the new lease be accepted? (Hint: Make sure you use 1% per month.)
b. If the store owner decided to bargain with the mall's owner over the new lease payment, what
new lease payment would make the store owner indifferent between the new and old leases?
(Hint: Find FV of the old lease's original cost at t 9; then treat this as the PV of a 51-period
annuity whose payments represent the rent during months 10 to 60.)
c. The store owner is not sure of the 12% WACC-it could be higher or lower. At what nominal
WACC would the store owner be indifferent between the two leases? (Hint: Calculate the
differences between the two payment streams; then find its IRR.

12.19 A mining company is deciding whether to open a strip mine, which costs $2 million. Cash inflows
of $13 million would occur at the end of Year 1. The land must be returned to its natural state at a cost
of $12 million, payable at the end of Year 2.

a. Plot the project's NPV profile.

b. Should the project be accepted if WACC is 10%? If WACC 20%? Explain

your reasoning.

c. Think of some other capital budgeting situations in which negative cash flows during or at the
end of the project's life might lead to multiple IRRs.
d. What is the project's MIRR at WACC 10%? At WACC 20%? Does MIRR lead to the same
accept/reject decision for this project as the NPV method? Does the MIRR method always lead
to the same accept/reject decision as NPV? (Hint: Consider mutually exclusive projects that differ
in size.)

12.20 A project has annual cash flows of $7,500 for the next 10 years and then $10,000 each year for
the following 10 years. The IRR of this 20-year project is 10.98%. If the firm's WACC is 9%, what is the
project's NPV?

12.21 Project X costs $1,000, and its cash flows are the same in Years 1 through 10. Its IRR is 12%, and
its WACC is 10%. What is the project's MIRR?
12.22 A project has the following cash flows:

Years Project
0 -500
1 -202
2 -X
3 196
4 350
5 451
This project requires two outflows at Years 0 and 2, but the remaining cash flows are positive. Its WACC
is 10%, and its MIRR is 14.14%. What is the Year 2 cash outflow?

ANSWER
5.0 HYBRID FINANCING

20-4 BALANCE SHEETS EFFECTS OF LEASING

Two textile companies, McDaniel-Edwards Manufacturing, and Jordan-Hocking Mills, began

operations with identical balance sheets. A year later both required additional manufacturing capacity
at a cost of $200,000. McDaniel-Edwards obtained a5-year, $200,000 loan at an 8% interest rate from
its bank. Jordan-Hocking on the other hand, decided to lease the required $200,000 capacity from
National Leasing for 5 years; an 8% return was built into the lease The balance sheet for each company,
before the asset increases, is as follows:

Debt $200,000
Equity 200,00
Total assets $400,000 Total liabilities & equity $400,00
a. Show the balance sheet of each firm after the asset increase, and calculate each firm's new
debt ratio. lease is kept off the balance sheet.) (Assume that Jordan-Hocking's lease is kept off
the balance sheet.
b. Show how Jordan-Hocking’s balance sheet would have looked immediately after the financing
if it had capitalized the lease.
c. Would the rate of return (1) on assets and (2) on equity be affected by the choice of financing?
If so, how?
20-5 LEASE VS BUY

Morris-Meyer Mining Company must install $1.5 million of new machinery in its Nevada mine. It can
obtain a bank loan for 100% of the required amount. Alternatively, a Nevada investment banking firm
that represents a group of investors believes that it can arrange for a lease financing plan. Assume that
the following facts apply.

1. The equipment falls in the MACRS 3-year class. The applicable MACRS rates are 33%, 45%,
15%, and 7%.
2. Estimated maintenance expenses are $75,000 per year.
3. Morris-Meyer's federal-plus-state tax rate is 40%.
4. If the money is borrowed, the bank loan will be at a rate of 15%, amortized in 4 equal
installments to be paid at the end of each year.
5. The tentative lease terms call for end-of-year payments of $400,000 per year for 4 years.
6. Under the proposed lease terms, the lessee must pay for insurance, property taxes, and
maintenance.
7. The equipment has an estimated salvage value of $400,000, which is the expected market
value after 4 years, at which time Morris-Meyer plans to replace the equipment regardless of
whether the firm leases or purchases it. The best estimate for the salvage value is $400,000,
but it may be much higher or lower under certain circumstances.
To assist management in making the proper lease-versus-buy decision, you are asked to
answer the following questions.
a. Assuming that the lease can be arranged, should Morris-Meyer lease or borrow and buy
the equipment? Explain.
b. Consider the $400,000 estimated salvage value. Is it appropriate to discount it at the same
rate as the other cash flows? What about the other cash flows--are they all equally risky?
Explain.
20-8 LEASE ANALYSIS

As part of its overall plant modernization and cost reduction program, the management of Tanner-
Woods Textile Mills has decided to install a new automated weaving loom. In the capital budgeting
analysis of this equipment, the IRR of the project was 20% versus a project-required return of 12%.

The loom has an invoice price of $250,000, including delivery and installation charges. The funds
needed could be borrowed from the bank through a 4-year amortized loan at a 10% interest rate, with
payments to be made at year-end. In the event the loom is purchased, the manufacturer will contract
to maintain and service it for a fee of $20,000 per year paid at year-end. The loom falls in the MACRS
5-year class, and Tanner-Woods's marginal federal-plus-state tax rate is 40%. The applicable MACRS
rates are 20%, 32%, 19%, 12%, 11%, and 6%.

United Automation Inc., maker of the loom, has offered to lease the loom to Tanner-Woods for $70,000
upon delivery and installation (at t = 0) plus 4 additional annual lease payments of $70,000 to be made
at the end of Years 1 through 4. (Note that there are 5 lease payments in total.) The lease agreement
includes maintenance and servicing. Actually, the loom has an expected life of 10 years, at which time
its expected salvage value is zero; however, after 4 years, its market value is expected to equal its book
value of $42,500. Tanner-Woods plans to build an entirely new plant in 4 years, so it has no interest in
leasing or owning the proposed loom for more than that period.

a. Should the loom be leased or purchased? (Ans: Purchase; NPV = -$185,112)

b. The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the
appropriate salvage value pretax discount rate is 15%. What would be the effect of a salvage
value risk adjustment on the decision? (Ans: Lease; NPV = -$187,534)
c. The original analysis assumed that Tanner-Woods would not need the loom after 4 years. Now
assume that the firm will continue to use the loom after the lease expires. Thus, if it leased,
Tanner-Woods would have to buy the asset after 4 years at the then-existing market value,
which is assumed to equal the book value. What effect would this requirement have on the
basic analysis? (No numerical analysis is required; just verbalize.)
6. CAPITAL STRUCTURE

OPERATING LEVERAGE AND BREAK-EVEN ANALYSIS

Oriental Electronics produces stereo components that sell at P = $100 per unit. Oriental's fixed costs
are $200,000, variable costs are $50 per unit, 5,000 components are produced and sold each year, EBIT
is currently $50,000, and Oriental's assets (all equity-financed) are $500,000. Oriental can change its
production process by adding $400,000 to assets and $50,000 to fixed operating costs. This change
would (1) reduce variable costs per unit by $10 and (2) increase output by 2,000 units, but (3) the sales
price on all units would have to be lowered to $95 to permit sales of the additional output. Oriental
has tax loss carry-forwards that cause its tax rate to be zero; it uses no debt; and its average cost of
capital is 10%.

a. Should Oriental make the change? Why or why not?

b. Would Oriental's break-even point increase or decrease if it made the change?
c. Suppose Oriental was unable to raise additional equity financing and had to borrow the
$400,000 at an interest rate of 10% to make the investment. Use the DuPont equation to find
the expected ROA of the investment. Should Oriental make the change if debt financing must
be used? Explain.

15-2 OPTIMAL CAPITAL STRUCTURE

Jackson Trucking Company is in the process of setting its target capital structure. The CFO believes that
the optimal debt-to-capital ratio is somewhere between 20% and 50%, and her staff has compiled the
following projections for EPS and the stock price at various debt levels:

Debt/Capital Projected EPS Projected

Ratio (%) Stock Price
20 $3.20 $35.00
30 3.45 36.50
40 3.75 36.25
50 3.50 35.50

Assuming that the frim uses only debt and common equity, what is Jackson’s optimal capital structure?
At what debt-to-capital ratio is the company’s WACC minimized?
15-6 UNLEVERED BETA

The Weaver Watch Company sells watches for $25, fixed costs are $140,000, and variable costs are
$15 per watch.

a. What is the firm's gain or loss at sales of 8,000 watches? At

18,000 watches?

b. What is the break-even point? Illustrate by means of a chart.

573

c. What would happen to the break-even point if the selling price was raised to $31? What is the
significance of this analysis?

d. What would happen to the break-even point if the selling price was raised to $31 but variable costs
rose to $23 a unit?

15-12 BREAKEVEN AND LEVERAGE

Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for
$28.80 per set, and this year's sales are expected to be 450,000 units. Variable production costs for
the expected sales under present production methods are estimated at $10,200,000, and fixed
production (operating) costs at present are $1,560,000. WCC has $4,800,000 of debt outstanding at
an interest rate of 8%. There are 240,000 shares of common stock outstanding, and there is no
preferred stock. The dividend payout ratio is 70%, and WCC is in the 40% federal-plus-state tax bracket.

The company is considering investing $7,200,000 in new equipment. Sales would not increase, but
variable costs per unit would decline by 20%.

Also, fixed operating costs would increase from $1,560,000 to $1,800,000. WCC could raise the
required capital by borrowing $7,200,000 at 10% or by selling 240,000 additional shares of common
stock at $30 per share.

a. What would be WCC's EPS (1) under the old production process, (2) under the new process if
it uses debt, and (3) under the new process if it uses common stock?
b. At what unit sales level would WCC have the same EPS assuming it undertakes the investment
and finances it with debt or with stock? /Hint: V = variable cost per unit = $8,160,000 =
450,000, and EPS = [(PQ-VQ-F-1)(1 - T)]/N. Set EPSStock = EPSDeb, and solve for Q.)
c. At what unit sales level would EPS = 0 under the three production/ financing setups that is,
under the old plan, the new plan with debt financing, and the new plan with stock financing?
 (Hint: Note that Void = $10,200,000/450,000, and use the hints for part b, setting the EPS
equation equal to zero.)
d. On the basis of the analysis in parts a through c, and given that operating leverage is lower
under the new setup, which plan is the riskiest, which has the highest expected EPS, and which
would you recommend? Assume that there is a fairly high probability of sales falling as low as
250,000 units. Determine EPSDebt and EPSStock at that sales level to help assess the
riskiness'of the two financing plans.

ANSWERS