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Raymond Supply, a national hardware chain, is considering purchasing a smaller c

ID: 2753244 • Letter: R

Question

Raymond Supply, a national hardware chain, is considering purchasing a smaller chain, Strauss & Glazer Parts (SGP). Raymond's analysts project that the merger will result in the following incremental free cash flows, tax shields, and horizon values:

Assume that all cash flows occur at the end of the year. SGP is currently financed with 30% debt at a rate of 10%. The acquisition would be made immediately, and if it is undertaken, SGP would retain its current $15 million of debt and issue enough new debt to continue at the 30% target level. The interest rate would remain the same. SGP's pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8% and the market risk premium is 4%. What is the value, in millions, of SGP to Raymond?

Year 1 2 3 4 Free cash flow $1 $3 $3 $7 Unlevered horizon value 75 Tax shield 1 1 2 3 Horizon value of tax shield 30

Explanation / Answer

Cost of Equity = Risk Free Rate + Beta * Market Risk Premium = 8% + 2 * 4% = 16%.

Weighted Average Cost of Capital

      = Weight of debt * Cost of debt * (1 – Tax Rate) + Weight of Equity * Cost of Equity

      = 0.30*10%*(1 - 0.34) + 0.70*16% = 13.18%.

The Cash Flows would be:

Total Value of operations of SGP = $79.64 million

Value of SGP to Raymond = Total Value of Operations - Value of Debt

                                            = 79.64 - 15 = $64.64 million

Year Cash Flow Discounted Cash Flow 0 0 0.00 1 2 1.77 2 4 3.12 3 5 3.45 4 117 71.30 Total 79.64