13-4 Suppose Lima Locomotive Company, which has a high beta as well as great dea
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13-4 Suppose Lima Locomotive Company, which has a high beta as well as great deal of corporate risk, merged with Homestake Patterns Inc. Homestake’s sales rise during recessions, when people are more likely to make their own cloths, and, consequently, its beta is negative but its corporate risk is relatively high. What would the merger do to the costs of capital in the consolidated company’s locomotive engine division and in its patterns division?Suppose a firm estimates its cost of capital for the coming year to be 10 percent. What are reasonable costs of capital for evaluating average-risk projects, high-risk projects, and low-risk projects?Explanation / Answer
Suppose a firm estimates its cost of capital for the coming year to be 10 percent. What are reasonable costs of capital for evaluating average-risk projects, high-risk projects, and low-risk projects?
In order to determine reasonable costs of capital for average, high and low risk projects the firm should develop risk-adjusted costs of capital for each category of risk based on the concept of divisional WACC. If a firm estimates that its cost of capital for the coming year will be 10%, the firm should use 10% as the basis for its average risk projects since the firm will need to achieve a minimum of a 10% return on all its projects. Typically, a high-risk project has the potential for higher returns and a low-risk project will typically yield lower returns. Therefore, the firm could set the cost of capital for its high-risk projects at 12% and the cost of capital for low risk projects at 8%. Since the average risk project has a 10% cost of capital, the overall risk of the firms projects will be equal to the 10% cost of capital. Similarly, if the firm's high-risk projects are particularly risky, they could be set at a 15% cost of capital and the low-risk projects will be adjusted down to a 5% cost of capital. The ultimate goal is that the portfolio of the firm's projects will achieve the required 10% return or greater so that the cost of capital to fund the projects is covered. The assignment of risk is somewhat subjective but it is better than not adjusting the risk at all.
If you don't want to use the CAPM (Capital Asset Pricing Model.) Consider that cost of capital should be approximately equal to what the stock market expects for your rate of return. If you are in a risky business like semiconductor equipment, the market will require a higher rate of return than say Hershey's chocolates.
You could probably use 12% for average risk. 16-18% for high risk projects, and 8% for low risks projects.
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What would the merger do to the costs of capital in the consolidated
A merger occurs when one firm assumes all the assets and all the liabilities of another. The acquiring firm retains its identity, while the acquired firm ceases to exist. A majority vote of shareholders is generally required to approve a merger. A merger is just one type of acquisition. One company can acquire another in several other ways, including purchasing some or all of the company's assets or buying up its outstanding shares of stock.
In general, mergers and other types of acquisitions are performed in the hopes of realizing an economic gain. For such a transaction to be justified, the two firms involved must be worth more together than they were apart. Some of the potential advantages of mergers and acquisitions include achieving economies of scale, combining complementary resources, garnering tax advantages, and eliminating inefficiencies. Other reasons for considering growth through acquisitions include obtaining proprietary rights to products or services, increasing market power by purchasing competitors, shoring up weaknesses in key business areas, penetrating new geographic regions, or providing managers with new opportunities for career growth and advancement. Since mergers and acquisitions are so complex, however, it can be very difficult to evaluate the transaction, define the associated costs and benefits, and handle the resulting tax and legal issues.
"In today's global business environment, companies may have to grow to survive, and one of the best ways to grow is by merging with another company or acquiring other companies," consultant Jacalyn Sherriton told Robert McGarvey in an interview for Entrepreneur. "Massive, multibillion-dollar corporations are becoming the norm, leaving an entrepreneur to wonder whether a merger ought to be in his or her plans, too," McGarvey continued.
When a small business owner chooses to merge with or sell out to another company, it is sometimes called "harvesting" the small business. In this situation, the transaction is intended to release the value locked up in the small business for the benefit of its owners and investors. The impetus for a small business owner to pursue a sale or merger may involve estate planning, a need to diversify his or her investments, an inability to finance growth independently, or a simple need for change. In addition, some small businesses find that the best way to grow and compete against larger firms is to merge with or acquire other small businesses.
In principle, the decision to merge with or acquire another firm is a capital budgeting decision much like any other. But mergers differ from ordinary investment decisions in at least five ways. First, the value of a merger may depend on such things as strategic fits that are difficult to measure. Second, the accounting, tax, and legal aspects of a merger can be complex. Third, mergers often involve issues of corporate control and are a means of replacing existing management. Fourth, mergers obviously affect the value of the firm, but they also affect the relative value of the stocks and bonds. Finally, mergers are often "unfriendly"
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