Merger Analysis TransWorld Communications Inc., a large telecommunications compa

Question

Merger Analysis

TransWorld Communications Inc., a large telecommunications company, is evaluating the possible acquisition of Georgia Cable Company (GCC), a regional cable company. TransWorld's analysts project the following post-merger data for GCC (in thousand of dollars):

If the acquisition is made, it will occur on January 1, 2015. All cash flows shown in the income statements are assumed to occur at the end of the year. GCC currently has a capital structure of 40% debt, but Trans World would increase that to 50% if the acquisition were made. GCC, if independent, would pay taxes at 20%; but its income would be taxed at 40% if it were consolidated. GCC's current market-determined beta is 1.55, and its investment bankers think that its beta will rise to 1.65 if the debt ratio were increased to 50%. The cost of goods sold is expected to be 75% of sales, but could vary somewhat. Depreciation-generated funds would be used to replace worn-out equipment, so they would not be available to TransWorld's shareholders. The risk-free rate is 8%, and the market risk premium is 4%. Do not round intermediate calculations.

What is the appropriate discount rate for valuing the acquisition?
% (to 2 decimals)

What is the continuing value?
$ thousand (to 1 decimal)

What is the value of GCC to TransWorld?
$ thousand (to 1 decimal)

2015 2016 2017 2018 Net Sales $431 $521 $560 $607 Selling and administrative expense 44 52 61 71 Interest 18 21 24 27 Tax rate after merger 40% Cost of goods sold as a percent of sales 75% Beta after merger 1.65 Risk-free rate 8% Market risk premium 4% Continuing growth rate of cash flow available to TransWorld 9%

Explanation / Answer

Solution:

1. Since the net cash flows are equity returns, the appropriate discount rate is that cost of equity which reflects the riskiness of the cash flow stream. This cost is GCC’s cost of equity:

ks = kRF + (RPM)b = 8% + (4%)1.65 = 14.6%.

2.

Net Income = Net Sales – Cost of goods sold – Selling expense – Interest

Net Income = $607 – 0.75*$607 - $71 - $27

Net Income = $53.75

Continuing value = $53.75(1.09)/(0.146 – 0.09)

Continuing value = $1,046.21

3.

The value of GCC to Transworld is

V = $27.45/1.146 + $34.35/1.146^2 + $33/1.146^3 + $32.25/1.146^4

V = $90.73

2015 2016 2017 2018 Sales 431 521 560 607 COGS 323.25 390.75 420 455.25 Gross profit 107.75 130.25 140 151.75 Selling/Adm 44 52 61 71 EBIT 63.75 78.25 79 80.75 Interest 18 21 24 27 EBT 45.75 57.25 55 53.75 Taxes (40%) 18.3 22.9 22 21.5 Net Income 27.45 34.35 33 32.25

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