This is the question that I need additional answering to. It is on your system.
ID: 2739649 • Letter: T
Question
This is the question that I need additional answering to. It is on your system. Q: A sporting goods manufacturer has decided to expand into a related business. Management estimates that to build and staff a facility of the desired size and to attain capacity operations would cost $450 million in present value terms. Alternatively, the company could acquire the division of another company. The book value of this divisions assets is $250 million, and its earnings before interest and tax are presently $50 million. Publicly A: View answer What is missing is question #5. "Referring to the $450 million price tag as the replacement value of the division, what would you predict would happen to acquisition activity when market values of companies and divisions rise above their replacement values?" I hope you can help me. THANK YOU!
Explanation / Answer
Ans;
Minimum price the owner of the division should consider for its sale
Current earnings after interest and tax
Debt to Asset Ratio = 40%
Assets = $250M
Debt = 40% x Assets = $100M
Interest Rate = 10%
interest Bill = 10% x Debt = 10M
Earnings BIT= 50 M
Earnings BT = Earnings BIT - Interest Bill
Earnings BT=50M-10 =40 M
Tax Rate = 34%
Earnings = Earnings BT x (100% - Tax Rate
Earnings = $40M x (100% - 34%)
Earnings = $40M x 66% = $26.4M
Current Earnings Multiple
Using the industry average valuation of 12x earnings, the division's value is [ Value = 12 x $$26.4M
= $316.8 M
Equivalent Earning Capacity
The amount of capital required to generate after-tax earnings of $16.104M would be [ Required Capital = ($26.4/ (100% - Tax Rate) ) / Market Interest Rate ]
Required Capital = ($26.4M / (100% - 34%) ) / 10%
Required Capital = ($26.4/ 66% ) / 10%
Required Capital =$400.60 M
The rational decision for the current owner would be to use the highest valuation of the division as the basis for
minimum asking price. He should therefore choose the figure of $400.6 M.
Maximum price the acquirer should be willing to pay
PV of the acquisition target will be nominally equivalent to that of the start-up option ($450 million and so won't be a significant consideration in the comparative valuation.
The value of the existing division should then be judged according to the total cost of ownership necessary toestablish it's equivalence to the startup option. For example, it's value must be discounted by the existing debt Value after Debt = $450M - $100M = $350M . If the debt burden is retained in any purchase, then the valuation might be adjusted upwards slightly by the tax
relief from interest payments on that debt [ Tax Relief = Debt x Interest x Tax ]
Tax Relief = $100M x 10% x 34% =$3.4M
Value after Debt and Tax Relief = $350M + $3.4M=$353.4M
Does it appear that an acquisition is feasible?
It initially appears that the acquisition is not viable, with an asking price of [ $400.6M ] and an offer of [ $353.4M.However, further evaluation would be required to establish the full value of the effective cost of ownership ofthe division.
For example, the established division might have ancillary business value that can be assimilated by the newventure in addition to the planned operations. The existing workforce and managerial expertise of the existingdivision might also offer productive and business leverage which the prospective buyer had initially overlooked.The existing division might also have assets which are surplus to the new venture's needs and so can be sold offto recover costs. here might also be unanticipated costs of ownership, for example possible labor disputes, retrenchment costs,
capital upgrades or replacements.And finally, the existing owner might also be subject to persuasion, given that the industry average valuation of12x earnings is well below his asking price and the initial offer.So there might be a middle ground upon which both parties can settle, somewhere above [ $$353.4M ] and below[ $400.6M ].
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