When a merger is a , it is easier to predict the post-merger cash flows of the t

Question

When a merger is a , it is easier to predict the post-merger cash flows of the target firm. Consider the following scenario: Three Waters Co. is considering an acquisition of Drugal Brewing Co. (DBC), and estimates that acquiring DBC will result in incremental after-tax net cash flows in years 1-3 of $12.0 min, $18.0 million, and $21.6 miion, respectively After the first three years, the incremental cash flows contributed by the DBC acquisition are expected to grow at a constant rate of 3% per year. Three Waters's current beta is 0.40, but its post-merger beta is expected to be 0.52. The risk-free rate is 5%, and the market risk premium is 7.10%. Based on this information, complete the following table by selecting the appropriate values: Value Post-merger cost of equity Continuing value in year 3 The value of Drugal Brewing Co. (DBC)'s contribution to Three Waters Co. Drugal Brewing Co. (DBC) has 5 million shares of common stock outstanding. What is the largest tender offer Three Waters Co. should make on each of Drugal Brewing Co. (DBC)'s shares? O $69.53 O $83.44 O $55.62

Explanation / Answer

Using CAPM, Cost of equity, r = Rf + beta x MRP = 5% + 0.52 x 7.1% = 8.69%

Value in year 3, P3 = FCF3 x (1 + g) / (r - g) = $390.86 million

Value today = FCF1 / (1 + r) + FCF2 / (1 + r)^2 + (FCF3 + P3) / (1 + r)^3

= 12 / 1.0869 + 18 / 1.0869^2 + (21.6 + 390.86) / 1.0869^3

= $347.49 million

Price per share = 347.49 / 5 = $69.5

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