Penn Corp. is analyzing the possible acquisition of Teller Company. Both firms h

Question

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 $41 million, and that of Penn is $86 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 $59 million in cash to Teller's shareholders.

What is the cost of each alternative? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)

What is the NPV of each alternative? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)

Which alternative should Penn choose?

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 $41 million, and that of Penn is $86 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 $59 million in cash to Teller's shareholders.

Explanation / Answer

a. Computation of cost of each alternative:
The cash cost is the amount of cash offered
Therefore, cash cost = $59 million.
To calculate the cost of the stock offer,
cost of the stock offer = percentage of the acquiring firm * (market value of the acquiring firm + the value of the target firm)
here, percentage of the acquiring firm = 40%
market value of the acquiring firm = $86 million
value of the target firm = $41 million + Present value of the incremental cash flows generated by the target firm i.e., $2million/10%
= $41 + $20 = $61milliom
Therefore, cost of the stock offer = 0.40($86 + $61) = $58.8million

b. Computation of NPV of each alternative:
Formula for NPV = value of the target firm - Cost of acquisition
NPV cash = $61million - $59 = $2million
NPV stock = $61million - $58.8million = $2.2million

c. Penn should choose stock because NPV stock is more than NPV cash and Cost of Stock is less than cash cost, which is more beneficial.

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