Novell, which had a market value of equity of $2 billion and a beta of 1.50, ann

Question

Novell, which had a market value of equity of $2 billion and a beta of 1.50, announced that it was acquiring WordPerfect, which had a market value of equity of $ 1 billion, and a beta of 1.30. Neither firm had any debt in its financial structure at the time of the acquisition, and the corporate tax rate was 40%.

a. Estimate the beta for Novell after the acquisition, assuming that the entire acquisition was financed with equity.

b. Assume that Novell had to borrow the $ 1 billion to acquire WordPerfect. Estimate the beta after the acquisition.

Explanation / Answer

(a) The beta for Novell would be the weighted average of the two firms since it is like calculating beta of portfolio of 2 stocks. The resultant beta would be = (2*1.5 + 1*1.3)/3 = 1.43

(b) If Novell borrows $ 1 billion, the the resultant beta would be the levered beta which will have to be adjusted for the debt. The unlevered beta of the two firms would be as calculated above at 1.43 and levered beta will be : BetaL = BetaU * [1 + (1-tax rate) * D/E]

Now the Debt is $1 billion and equity is $2 billion (since the WordPerfect equity would be purchased by Novell using debt).

BetaL = 1.43 * [1+(1-40%)*1/2] = 1.86

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