Benson Oil is being considered for acquisition by Dodd Oil. The combination, Dod

Question

Benson Oil is being considered for acquisition by Dodd Oil. The combination, Dodd believes, would increase it cash inflows by $ 25,000 for each of the next 5 years and by $ 50,000 for each of the following 5 years. Benson has high financial leverage, and Dodd can expect its cost of capital to increase from 12% to 15%, if the merger is undertaken. The cash price of Benson is $ 125,000.

Would you recommend the merger?

Would you recommend the merger if Dodd could use the $ 125,000 to purchase equipment that will return cash inflows by $ 40,000 per year for each of the next 10 years?

If the cost of capital did not change with the merger, would your decision in part b be different? Explain.

Explanation / Answer

BEFORE GOING TO THE ANSWER PART WE WILL CALCULATE SOME PVIFA.

PVIFA @15% FOR 5YEARS = 3.3522

PVIFA @15% FOR 10YEARS = 5.0188

PVIFA @15% FOR 6-10 YEARS (5.0188 - 3.3522) = 1.6666

PVIFA @12% FOR 10 YEARS = 5.6502

PVIFA @12% FOR 5YEARS = 3.6048

PVIFA @12% FOR 6 - 10YEARS (5.6502 - 3.6048) = 2.0454

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NPV OF MERGER OPTION

= -$125000 + $25000 * PVIFA15%,5PERIODS + $50000 * PVIFA 15% 6-10 PERIODS

= -$125000 + $25000 * 3.3522 + $50000 * 1.6666

= -$125000 + $83805 + $83330

= $42135

YEAS THE MERGER CAN BE UNDERTAKEN, AS THE NPV IS POSITIVE.

ASSUMING THAT THE COST OF CAPITAL REMAINED AT 12%

NPV OF THE PURCHASE OF EQUIPEMENT

= -$125000 + $40000 * PVIFA 12% , 10 PERIODS

= -$125000 + $40000 * 5.6502

= -$125000 + $226008

= $101008

IN THIS CASE THE MERGER SHOULDNOT BE UNDERTAKEN BECAUSE THE NPV OF PURCHASE OF EQUIPEMENT IS HIGHER THAN THE NPV OF MERGER.

IF COST OF CAPITAL WITH MERGER IS AT 12% NPV,

= -$125000 + $25000 * PVIFA12%,5PERIODS + $50000 * PVIFA 12% 6-10 PERIODS

= -$125000 + $25000 * 3.6048 + $50000 * 2.0454

= -$125000 + $90120 + $102270

= $67390

NO IF THE COST OF CAPITAL REMAINS AT 12% THAN ALSO THE NPV OF MERGER IS LESS THAN THE NPV OF PURCHASE OF EQUIPEMENT, SO WE WILL GO WITH PURCHASE OF EQUIPEMENT.

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