The following projections relate to two recently merged firms: Revenue = $7,280,

Question

The following projections relate to two recently merged firms:

Revenue = $7,280,000
Cost of Goods Sold (without operating synergy) = 88% of revenue
Cost of Goods Sold (with operating synergy) = 85% of revenue
Depreciation Expense (not included in the Cost of Goods Sold) = $380,000
Tax Rate = 40%
Change in Working Capital = $26,000
Capital Spending = $220,000
Cost of Capital = 12.50%
Expected perpetual growth rate = 4.50%

After achieving operating synergy, the combined firms can reduce the cost of capital to 12.00% by adding long-term debt. What will be the value of the financial synergy created by moving to this improved capital structure?

Select one:

A. $467,667

B. $548,996

C. $654,879

D. None of the above

Explanation / Answer

Considering Current Time to be the end of Year 0, one can reasonably assume that the given projections are for the upcoming year, which is the end of Year 1. Further, as has been mentioned, the two merged firms have achieved operational synergy and hence the COGS for the combined entity would be equal to 85 % of the entity's revenue.

Revenue = $ 7280000

LESS: COGS = 85 % of Revenue = 0.85 x 7280000 = $ 6188000

Gross Profit = $ 1092000

LESS: Depreciation = $ 380000

EBIT = $ 712000

LESS: Tax at 40 % = 712000 x 0.4 = $ 284800

NOPAT = 712000 - 284800 = $ 427200

ADD: Depreciation = $ 380000

LESS: Change in Working Capital (WC) = $ 26000

LESS: Capital Spending = $ 220000

Free Cash Flow (FCF) = $ 561200

WACC without financial synergy = 12.5 % and WACC with financial synergy = 12 %

Perpetual Growth Rate = 4.5 %

Firm Value with Financial Synergy = V1 = 561200 / (0.12 - 0.045) = $ 7482666.667

Firm Value with Financial Synergy = V2 = 561200 / (0.125 - 0.045) = $ 7015000

Value of Synergy = V1 - V2 = 7482666.667 - 7015000 = $ 467666.67 or $ 467667 approximately.

Hence, the correct option is (A).

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