Western Gas & Electric Co. (WG&E;) is considering an acquisition of Zebra Engine

Question

Western Gas & Electric Co. (WG&E;) is considering an acquisition of Zebra Engineering Corp. (ZEC), and estimates that acquiring ZEC will result in incremental after-tax net cash flows in years 1-3 of $8.0 million, $12.0 million, and $14.4 million, respectively. After the first three years, the incremental cash flows contributed by the ZEC acquisition are expected to grow at a constant rate of 4% per year. WG&E;'s current beta is 1.60, but its post-merger beta is expected to be 2.08. The risk-free rate is 5.5%, and the market risk premium is 7.60%. Based on this information, complete the following table by selecting the appropriate values Value Post-merger cost of equity Projected value of the cash flows at the end of three years The value of Zebra Engineering Corp. (ZEC)'s contribution to Western Gas & Electric Co. (WG&E;) Zebra Engineering Corp. (ZEC) has 4 million shares of common stock outstanding. What is the largest tender offer Western Gas & Electric Co. (WG&E;) should make on each of Zebra Engineering Corp. (ZEC)'s shares? O $21.39 O $21.38 O $17.82 O $14.26

Explanation / Answer

Post merger Cost of Equity

Beta = 2.08
Risk Free Rate = 5.5%
Market Risk Premium = 7.60%

Cost of Equity = Risk Free Rate + Beta*Market Risk Premium
Cost of Equity = 5.5% + 2.08*7.60%
Cost of Equity = 21.31 %

2)
Terminal Value at the end of Year 3 = Cash Flow at the end of Year 4 / (Cost - Growth Rate)
Terminal Value at the end of Year 3 = Cash Flow3 * (1+g) / (Cost - Growth Rate)
Terminal Value at the end of Year 3 = 14.4* (1+4%) / (21.31% - 4%)
Terminal Value at the end of Year 3 = 14.98 / 17.31 %
Terminal Value at the end of Year 3 = 86.54 Million

3)
Value of ZEC Now = CF1/(1+r)1 + CF2/(1+r)2 + CF3/(1+r)3 + TV3/(1+r)3
Value of ZEC Now = 8/(1+21.31%)1 + 12/(1+21.31%)2 + 14.4/(1+21.31%)3 + 86.54/(1+21.31%)3
Value of ZEC Now = 8/(1.2131)1 + 12/(1.2131)2 + 14.4/(1.2131)3 + 86.54/(1.2131)3
Value of ZEC Now = 6.59 + 8.15 + 8.07 + 48.48
Value of ZEC Now = 71.29 Million

4)
No. of Common Stock Outstanding = 4 Million
Value = 71.29 Million

Per Share = 71.29/4 = $ 17.82

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