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Makonis Co, a listed company producing motor cars, wants to acquire Nuvola Co, an engineering company involved
in producing innovative devices for cars. Makonis Co is keen to incorporate some of Nuvola Co’s innovative devices
into its cars and thereby boosting sales revenue.
The following financial information is provided for the two companies:
Makonis Co Nuvola Co
Current share price $5·80 $2·40
Number of issued shares 210 million 200 million
Equity beta 1·2 1·2
Asset beta 0·9 1·2
It is thought that combining the two companies will result in several benefits. Free cash flows to firm of the combined
company will be $216 million in current value terms, but these will increase by an annual growth rate of 5% for the
next four years, before reverting to an annual growth rate of 2·25% in perpetuity. In addition to this, combining the
companies will result in cash synergy benefits of $20 million per year, for the next four years. These synergy benefits
are not subject to any inflationary increase and no synergy benefits will occur after the fourth year. The debt-to-equity
ratio of the combined company will be 40:60 in market value terms and it is expected that the combined company’s
cost of debt will be 4·55%.
The corporation tax rate is 20%, the current risk free rate of return is 2% and the market risk premium is 7%. It can
be assumed that the combined company’s asset beta is the weighted average of Makonis Co’s and Nuvola Co’s asset
betas, weighted by their current market values.
Makonis Co has offered to acquire Nuvola Co through a mixed offer of one of its shares for two Nuvola Co shares plus
a cash payment, such that a 30% premium is paid for the acquisition. Nuvola Co’s equity holders feel that a 50%
premium would be more acceptable. Makonis Co has sufficient cash reserves if the premium is 30%, but not if it is
50%.Dear Sirs,
I dont understand from where these numbers brought into the solution. “Total PV of cash flows (years 5 to perpetuity) = 262·55 x 1·0225 /(0·09 – 0·0225) x 1·09–4 = $2,817·51 million”Please do not type out a whole question. Just state the name of the question and the date of the exam, because I have all past exam questions and answers 🙂
For a growing perpetuity we use the growth model formula from the formula sheet.
Do = 282.55 – 20 = 262.55 (because the 20 synergy disappears as per the question).
g = 0.0225 (2.25%)
r = 0.09 (9%)Using these figures in the formula would give the PV ‘now’ if the first flow was in 1 years time.
However here, the first flow is in 5 years time, which is 4 years later. Therefore the answer then needs discounting for 4 years a 9%.
( 1.09^-4 is the same as 1/(1.09^4) and is the 4 year discount factor at 9%.)Dear John,
Thank you for your explanation. I will consider your suggestion whenever i have any query i.e. i will not write the question in full.
Thank you again,
Bizuayehu
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