Cash versus Stock Payment [LO3] Penn Corp. is analyzing the possible acquisition

Question

Cash versus Stock Payment [LO3] Penn Corp. is analyzing the possible acquisition of Teller Company. Both firms have no debt. Penn believes the acquisition will increase its total aftertax annual cash flows by $2 million indefinitely. The current market value of Teller is $43 million, and that of Penn is $89 million. The appropriate discount rate for the incremental cash flows is 10 percent. Penn is trying to decide whether it should offer 40 percent of its stock or $61 million in cash to Teller's shareholders. a. What is the cost of each alternative? b. What is the NPV of each alternative? c. Which alternative should Penn choose?

Explanation / Answer

Present value of annual cash flow = Annual Cash flow/Discount rate
=> $2,000,000 / 0.10 = $20,000,000

Cost of each alternative:
40% of Penn stock = $89,000,000 x 40% = $35,600,000
Paying Cash = $61,000,000

NPV of first alternative = -$35,600,000 + $20,000,000 = -$15,600,000
NPV of second alternative = -$61,000,000 + $20,000,000 = -$41,000,000

As the first alternative is less costly, it should be opted for. However, if we go by ideal logic, none of the options should be selected as both result in negative NPV.

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