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  1. Use the data for the three separate firms in the table below to answer the following questions. Answer each question independently of all other questions. (Topic: Mergers and Acquisitions)


Data for What Not, Inc. (in millions)
  What-Not, Inc. If-Not, Inc. Why-Not, Inc.
Earnings per share $4 $2 $2
Price per share $64 $28 $12
Price-earnings ratio 16 14 6
Number of shares 200,000 100,000 200,000
Total earnings $800,000 $200,000 $200,000
Total market value $12,800,000 $2,800,000 $2,400,000
Book Value:
Net working capital $1.1 $0.4 $0.3
Fixed asset 2.8 1.0 0.8
Debt 2.0 0.7 0.3
Equity 1.9 0.7 0.8

a.What are the cost and net present value of the combination of What-Not, Inc., and If-Not, Inc., if, as a result of the merger, the economies expected are $400,000 and What-Not, Inc. plans to pay $3 million in cash for If-Not, Inc.?

b.If What-Not acquires If-Not for $3 million in cash, how will the shareholders of each make out on the deal?

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c.If What-Not Inc., merges with Why-Not, Inc., there are no economic gains from the merger, and $1.2 million in stock is paid for Why-Not. Demonstrate the bootstrapping effect of the merger.

d.Calculate the apparent and true costs of the merger between What-Not, Inc. and If-Not, Inc., assuming expected economies of $400,000 and the shareholders of If-Not receive one share of What-Not for every two shares they hold.

e.Show the results of accounting for the merger between What-Not, Inc. and If-Not, Inc., using both pooling of assets and a purchase of assets methods, where If-Not is acquired for $3 million.


  1. Scrapgarden Products is evaluating a possible investment in a new plant costing $1200. By the end of a year they will know whether cash flows will be $150 a year in perpetuity or only $60 a year, but in either case the first cash flow will not occur until year 2.  Alternatively, they would be able to sell their plant in year 1 for $700 ($800, if things go well).  They assess a 60 percent chance that the project will turn out well and a 40 percent chance it will turn out badly.  Their opportunity costs of funds is 10 percent.  What should they do?  Use a decision tree approach.

(Topic: Real Option)


  1. Company X has an equity beta of 1 and 40% debt in its capital structure. The company has risk-free debt which costs 6% before taxes, and the expected rate of return on the market portfolio is 10%.  Company X is considering the acquisition of a new project which is expected to yield 25% on after-tax operating cash flows.  Company Y which is in the same product line (and risk class) as the project being considered, has an equity beta of 2.0 and has 20% debt in its capital structure.  If Company X finances the new project with 50% debt, should it be accepted or rejected?  Assume that the corporate tax rate, tc, for both companies is 40%.  Assume also perfect capital markets and ignore personal taxes and flotation costs.


Note:  The systematic risk of an unlevered company, U, and the systematic risk of the equity of a levered company, L, are related by




if the companies are identical apart from capital structure.  D and E denote the value of debt and equity of the levered firm. (Topic: Capital Structure, CAPM, Valuation)


  1. Suppose you are hired by a company to advise it on a potential takeover of another company in a somewhat different (but not completely different) product line. Explain a good procedure for estimating the value of the potential takeover. In your discussion, describe (1) appropriate measures of the riskiness of this venture; (2) how these risks get reflected in the discount rate; and also (3) comment on the measure beta and its advantages and disadvantages as a risk measure.

(Topic: Takeover)


  1. Company A has a market value of $40 million. Company B has a market value of $20 million. A proposed merger between them seems likely to reduce the standard deviation of their equity returns from 40% individually to 35% combined. What would you expect the market value of the combined company to be after the merger? Assume the CAPM assumptions hold.


  1. Compare the following approaches to valuation that were discussed in class:


  • Discounted Cash Flow;
  • Real Options;
  • Relative Valuation.


  1. Consider firm B as an unlevered firm and firm C as a levered firm with target debt-to-equity ratio (B/S) = 1. Both firms have exactly the same perpetual net operating income, EBIT = 180, before taxes. The before-tax cost of debt, rb, is the same as the risk-free rate.  The corporate tax rate = 0.5.  Given the following market parameters,


E(Rm) = 0.12   s2m = .0144     Rf = 0.06         bB = 1              bc = 1.5


  1. a) Find the cost of capital and value of each firm
  2. b) Evaluate the following four projects to determine their acceptance (or rejection) by firms B and C. What do the results of this evaluation tell you about leverage in a world with corporate taxes but no personal taxes? (Note rjm is the correlation between the unlevered free cash flows of each project and the market).

Projectj                         Costj               EBITj (after tax)                        σj                   rjm


1                      100                                9                    0.10                 0.6

2                      120                              11                    0.11                 0.7

3                        80                                9                    0.12                 0.8

4                      150                              18                    0.20                 0.9



  1. Private Ltd., a privately held company, has embarked on an acquisition strategy and has an opportunity to buy several other privately held companies. Before it completes its evaluations, however, it wants an option to buy one company in the next six months. How much is the option worth to Private Ltd., given that the estimated standard deviation of the firm to be acquired is 0.60, the value of each share is $50, and the estimated equivalent to an exercise price is $70? Assume the interest rate is 10 %.


  1. Explain the “real options” approach to valuation of project investments, and the claim that the “naïve” NPV rule which ignores the value of such options leads to adverse investment decisions. In your discussion compare two alternative situations, one where uncertainty involves probability distributions which are independently and identically distributed (i.i.d) over time, and another where there is substantial resolution of uncertainty over time.

(Topic: Real Option)

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