Raymond Supply, a national hardware chain, is considering purchasing a smaller c
ID: 2702155 • Letter: R
Question
Raymond Supply, a national hardware chain, is considering purchasing a smaller chain, Strauss & Glazer Parts (SGP). Raymond's analysts project that the merger will result in the following incremental free cash flows, tax shields, and horizon values:
Assume that all cash flows occur at the end of the year. SGP is currently financed with 30% debt at a rate of 10%. The acquisition would be made immediately, and if it is undertaken, SGP would retain its current $15 million of debt and issue enough new debt to continue at the 30% target level. The interest rate would remain the same. SGP's pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8% and the market risk premium is 4%. What is the value of SGP to Raymond?
Explanation / Answer
rsL = rRF + b(RPM) = 8% + 2.0(4%) = 16%. rsU = wdrd + wsrs = 0.30(10%) + 0.70(16%) = 14.2%.
Time line: (In millions) Financial calculator solution: (In millions) Inputs:
CF0 = 0; CF1 = 2; CF2 = 4; CF3 = 5; CF4 = 117; I/YR = 14.2 Output:
NPV = $76.96 million = Value of operations.
Value of equity = Value of operations Value of debt = $76.96 15 = $61.96 million
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