Can someone help me answer this question? Can you also show how to do it? 3. You

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Can someone help me answer this question? Can you also show how to do it?

3. You are analyzing an acquisition using either 100% debt or 100% equity as the only two financing solutions. You perform an analysis of capital sources and the impact on the firm's earnings for the S3 billion deal. ABC Inc. currently has 800 million shares outstanding and a market price of $50 per share. The firm has a cost of debt (before tax) of 7 percent. The target firm has S800 million in debt carrying a 12% rate that will be assumed by ABC Inc. You run an analysis that includes a five-year projection for the combined company to determine EBIT in Table 3. Using either all equity ($50 issuance price) or all debt (7%) to buy Target Co., assuming no flotation costs in this model, and assuming 30% tax rate, when is the deal accretive to earnings and how should the firm finance the acquisition? Table 3. Combined projection of EBIT for ABC Inc and Target Company & EPS for ABC Alone Without Acquisition Year 3 5,194,530 Year 4 Year 1 4.455,000 Year 0 Year 2 Year S Combined EBIT 4.500,000 Without ABC Acquisition

Explanation / Answer

First we have to find cost of capital or WACC or weighted average average cost of capital as here we have two sources of capital Debt and capital and this WACC would be used to find IRR and NPV using table 1 Formula for WACC is We*Ke+ Wd*Kd or weight of equity* cost of equity plus weight of debt * cost of debt

Here Debt-equity = 0.40 or 40% means company uses 40% debt and 60% equity in capital structure

bt-equity ratio= Debt/equity

while calculating we take cost of debt or Kd after tax as tax paid on( interest on borrowed capital) is deductible from profits hence profits are reduced and therefore tax saving and money saved is money earned so we take Kd after tax. Here Wd= 0.40 Kd after tax = 12*(1-0.30)= 8.4%

We = 0.6

To calculate Ke we will use Capital asset pricing model or CAPM model

formula = Rf+ beta( market return- Rf) here Rf means risk free rate or treasury rate =4%

so Ke using formula

4%+1.14(10%-4%)= 4% + 6.84%= 10.84%

Kd is 8.4% and Ke is 10.84% and Wd is 0.4 and We is 0.6

so WACC is 0.4 *8.4 + 0.6* 10.84%= 3.36+6.504= 9.864%

using 9.864% as WACC we find NPV and IRR

NPV is PV of Cash outflow - PV of cash inflow

here pv of cash outflow is $ 3 billion as outflow was spent at year 0 beginning so pv of any rate at year 0 beginning is 1 so therefore $3 billion * pvf at year 0 which is 1 so 3B *1= $3 billion

Cash inflow

first find Pvf of 9.864 at end of year 1,2,3,4 and 5 we have at year end

pvf of 9.864% at end of year 1 is 1/1+0.09864=1/1.09864= 0.910 at end of year 2 = 1/(1.09864)2?= 0.828 similarly for year 3 pvf is 0.754 for year 4 it is 0.686 and for year 5 it is 0.625

Now using PVF we will calculate PV of cash inflows

year 1 = 0.910*$550 million = $500.5 million

year 2 is 0.828* $700 million = $579.6 million and similarly for year 3,4 and 5 PV of CI is 622.05 M for year 4 is $823.2M and for year 5 is $ 0.625* 1500M= $937.5 M

Now total pv of cash inflows are $500.5+ 579.6+622.05+823.2+937.5= 3462.85 Million Dollars and our PV of cash outflow was $ 3 billion or 3000 Million so NPV = 3462.85-3000= 462.85 Million dollars as NPV is positive project can be accepted.

IRR is that rate which equates the PV of CO and PV of CI means where NPV is zero that rate is called IRR or internal rate of return so we have to find that rate where pv of cash inflows comes to $3 billion making NPV = zero   

Here we will find one NPV at higher rate which will give us negative NPV and one NPV at lower rate which will give us positive NPV Here rate means discount rate or rate of discounting

at 15% discount rate PVF are 0.870,0.756,0.658,0.572,0.497 and PV of CI = 478.5+529.2+542.85+686.4+745.5=2982.45 and PV of CO is $3000 M hence NPV is negative or -17.55 Million dollars

At 14% discount rate NPV would be positive hence IRR is between 14 and 15%

At 14% PVF rates are 0.877,0.769,0.674,0.592,0.519 and PV of cash inflows is 482.35+538.3+556.05+710.4+778.5=3065.6 and Pv of outfolow is $3000 million hence NPV is $65.6 million

now apply IRR formula which is Lower rate + NPV at lower rate /NPV at lower rate - NPV at higher rate * Higer rate - lower rate Putting values 14%+ $65.6/65.6-(-17.55)*15%-14% = 14% +65.6/83.15* 1 = 14%+ 65.6/83.15= 14%+0.789= 14.789% if we discount at 14.789% NPV would be zero Hence IRR is 14.789%.

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