Question 1 Company A plans to acquire Company B. The acquisition would result in

Question

Question 1

Company A plans to acquire Company B. The acquisition would result in incremental cash flows for Company A of R15 million in each of the first five years. Company A expects to divest from Company B at the end of the fifth year for R100 million. The beta for Company A is 1.1, which is expected to remain unchanged after the acquisition. The risk-free rate, Rf, is 7 percent, and the expected market rate of return, Rm, is 15 percent. Company A is financed by 80 percent equity and 20 percent debt, and this leverage will also remain unchanged after the acquisition. Company A pays interest of 10 percent on its debt, which will remain unchanged after the acquisition.

1.1) Disregarding taxes, what is the maximum price that Company A should pay for Company B?

1.2)Company A has a share price of R35 per share and 15 million shares outstanding. If Company B shareholders are to be paid the maximum price determined in (1.1) via a new share issue, how many new shares will be issued, and what will be the post-merger share price? (5)

Explanation / Answer

Company A

Cost of equity(ke) = riskless rate + beta * risk premium

= 7% + 1.1(15%-7%)

= 15.8%

Cost of debt = Borrowing rate (1 - tax rate)

Debt + equity = Cost of capital = Weighted average of cost of equity and Capital cost of debt; weights based upon market value.

Cost of capital = kd [D/(D+E)] + ke [E/(D+E)] = 10%*20% + 15.8%*80% = 14.64%

PV of Cash Flows = R15million*PVAF(15%,5) + R100million*PVF(15%,5)

= R15million * 3.3522 + R100million * 0.497 = R50.283 million + R49.7million = R99.983 million

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