6. Merging and Acquisition question: American Hardware (AH), a national hardware
ID: 2616153 • Letter: 6
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6. Merging and Acquisition question: American Hardware (AH), a national hardware chain, is considering purchasing a smaller chain, Eastern Hardware (EH). American Hardware's analysts project that the merger will result in incremental free cash flows and interest tax savings. In the first two years, the incremental FCF is $3 million each year and the value increases to $3.5 million each year after the period. The tax savings are $0.5 million annually starting from the first year. They have determined that the appropriate discount rate for valuing EH (for both FCF and interest tax savings) is 17 percent. EH has 7 million shares outstanding and AH has 56 million shares outstanding. EH's current share price is $14.25 and AH's current share price is $28.25. What is the maximum price per share that AH should offer (under the condition that all of the proposed synergy value is distributed to a). the EH shareholders)? 6 marks] b). If the proposed synergy value is equally distributed between AH shareholders and EH shareholders (50% to all AH shareholders and 50% to all EH shareholders), what is the price per share that AH should offer? [7 marks] c). If AH has successfully purchased all of EH shares at the price of $18, what should AH share price be after the purchasing (assuming investors know the information precisely as described above)? [7 marks] Total [20 Marks]Explanation / Answer
Incremental Cash Flows are $ 3 million for the first two years, followed by $ 3.5 million from the third year onward. Tax Savings are $ 0.5 million in perpetuity beginning from the end of Year 1. The discount rate for both incremental FCFs and Tax Savings is 17 %.
PV of Incremental Cash Flow = P1 = 3 / 1.17 + 3 / (1.17)^(2) + (3.5 / 0.17) x 1 / (1.17)^(2) = $ 19.79 million
PV of Tax Savings = 0.5 / 0.17 = P2 = $ 2.94 million
Total Synergy Value = P1 + P2 = 19.79 + 2.94 = $ 22.73 million
EH has 7 million shares outstanding at a current price of $ 14.25 per share and AH has 56 million shares outstanding at a current price of $ 28.25 per share.
Value of AH = 56 x 28.25 = $ 1582 million and Value of EH = 7 x 14.25 = $ 99.75 million
If the entire merger gain/synergy is paid out to EH shareholder, total value paid for EH = Synergy + Value of EH = 22.73 + 99.75 = $ 122.48 million
Number of EH shares outstanding = 7 million
Maximum Price paid per share for EH = 122.48 / 7 = $ 17.497 per share
(b) If the synergy gain is divided 50-50 between AH and EH shareholders, then value paid for EH = (22.73/2) + 99.75 = $ 111.115 million
Price Paid per Share = 111.115 / 7 = $ 15.874 per share
(c) AH pays $ 18 for each share of EH, which implies that cash paid = 7 x 18 = $ 126 million
Cost of Merger = 126 - 99.75 = $ 26.25 million
Merger Gain = Synergy Gain = $ 22.73 million
Merger NPV for AH = Merger Gain - Cost of Merger = 22.73 - 26.25 = - $ 3.52 million
Value of AH after Merger Announcement = Original Value of AH + Merger NPV = 1582 - 3.52 = $ 1578.48 million
Price per Share of AH = 1578.48 / 56 = $ 28.19 per share
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