1 CHAPTER 21 Extra Calculation Example

2 APV Valuation Analysis (In Millions) Based on Post-Acquisition Cash Flows Net sales60.00$ 90.00$ Cost of goods sold (60%) Selling/administrative expense EBIT Taxes on EBIT (40%) NOPAT Total net operating capital Investment in net operating capital Free Cash Flow

3 Cash flows… continued

4 Interest Tax Savings after Merger Note: Tax savings = interest expense (Tax rate). The tax rate is 40% Interest expense Tax savings from interest2.00$ 2.60$ Interest expense Tax savings from interest2.60$ 2.80$ 3.26$

5 What is investment in net operating capital? Recall that firms must reinvest in order to replace worn out assets and grow. Investment in net operating capital = change in total net operating capital. This is equivalent to gross investment in operating capital minus depreciation

6 Non-Operating Assets Short-term investments and marketable securities are non-operating assets. The Target has none of these.

7 What is the appropriate discount rate to apply to the target’s cash flows? After acquisition, the free cash flows belong to the remaining debtholders in the target and the various investors in the acquiring firm: their debtholders, stockholders, and others such as preferred stockholders. These cash flows can be redeployed within the acquiring firm. (More...)

8 Discount rate… Free cash flow is the cash flow that would occur if the firm had no debt, so it should be discounted at the unlevered cost of equity, r sU The interest tax shields are also discounted at the unlevered cost of equity, r sU

9 Note: Comparison of APV with Corporate Valuation Model APV discounts FCF at r sU and also the tax shields at r sU; the value of the tax savings is incorporated explicitly. Corp. Val. Model discounts FCF at WACC, which has a (1-T) factor to account for the value of the tax shield. Both models give same answer if the capital structure is constant. But if the capital structure is changing, then APV should be used.

10 Discount Rate for Horizon Value The last year of projections must be at the target capital structure with constant growth thereafter. Discount the FCFs using the constant growth formula to find the unlevered horizon value. Discount the tax shields using the constant growth formula to find the horizon value of the tax shields.

11 Target’s data: r RF = 7%; RP M = 4%, beta = 1.3, w d =20%, r d = 9%. r sL = r RF + (RP M )b Target = 7% + (4%)1.3 = 12.2% r sU = w d r d + w s r sL = 0.20(9%) (12.2%)= 11.56% Discount Rate Calculations

12 Unlevered Horizon Value (Constant growth of 6%) Unlevered Horizon Value = (FCF 2015 )(1+g) r sU - g = $21.94(1.06) – 0.06 = $418.3 million.

13 Unlevered Value V UL = $11.7 (1.1156) 1 $10.5 (1.1156) $16.5 (1.1156) 3 + $20.7 (1.1156) 4 = $298.9 million. + $440.2 (1.1156) Free Cash Flow11.7$ 10.5$ 16.5$ 20.7$ 21.94$ Unlevered Horizon Value418.3$ Total11.7$ 10.5$ 16.5$ 20.7$ 440.2$

14 Unlevered Value The unlevered value is the value of the firm’s operations if it had no debt. In this case Lyons’ operations would be worth $298.9 million if it were financed with 100% equity.

15 Tax Shield Horizon Value Tax Shield Horizon Value = (TS 2015 )(1+g) r sU - g = $3.26(1.06) – 0.06 = $62.2 million.

16 Tax Shield Value V TS = $ 2.0 (1.1156) 1 $ 2.6 (1.1156) $ 2.6 (1.1156) 3 + $ 2.8 (1.1156) 4 = $45.5 million. + $ 65.5 (1.1156) Interest tax shield2.0$ 2.6$ $ 2.8$ 3.264$ Tax shield horizon value62.2$ Total2.0$ 2.6$ $ 2.8$ 65.5$

17 What Is the value of the Target Firm’s operations to the Acquiring Firm? (In Millions) Value of operations = unlevered value + value of tax shield = = $344.4 million

18 What is the value of the Target’s equity? The Target has $55 million in debt. V ops + non-operating assets – debt = equity million + 0 – 55 million = $289.4 million = equity value of target to the acquirer.