Martin Technologies Inc., a large electronics company, is evaluating the possibl

Question

Martin Technologies Inc., a large electronics company, is evaluating the possible acquisition of Columbia Electronics, a regional electronics company. Martin’s analysts project the following post-merger data for Columbia (in millions of dollars):

                                                    2015         2016           2017            2018

Net Sales                                                $300                $400                 $425             $500

Selling and administrative expenses            45                    55                     65                 80

Interest                                                     25                    30                     35                 40

Tax rate after merger

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. Columbia currently has a capital structure of 40% debt, but Martin would increase that to 50% if the acquisition were made. Columbia, if independent, would pay taxes at 20%; but its income would be taxed at 30% if it were consolidated. Columbia’s current market-determined beta is 1.15, and its investment bankers think that its beta would rise to 1.2875 if the debt ratio were increased to 50%. The cost of goods sold is expected to be 70% of sales, but it could vary somewhat. Depreciation-generated funds would be used to replace worn-out equipment, so they would not be available to Martin’s shareholders. The risk-free rate is 3%, and the market risk premium is 5%.

What is the value of Columbia to Martin? Do not round intermediate calculations.

$_____________million (to 2 decimals)

Tax rate after merger

30% Cost of goods sold as a percent of sales 70% Beta after merger 1.2875 Risk-free rate 3% Market risk premium 5% Continuing growth rate of cash flow available to Martin 4%

Explanation / Answer

Calcualtion of free cash flows 2015 2016 2017 2018 Net Sales 300 400 425 500 Cost of goods sold (70% of sales) 210 280 297.5 350 Selling & Administrative Expenses 45 55 65 80 Interest 25 30 35 40 Earnings Before Tax 20 35 27.5 30 Tax at 30% 6 10.5 8.25 9 Net Income 14 24.5 19.25 21 Since Depreciation funds are not available to share holders, the above the cash flows available to Martin's shareholders growth rate of cash flows 4% Expected cash flow in 2019 =21*1.04 21.84 Risk-free rate 3% Market risk premium 5% Beta after merger 1.2875 Required rate of return =3% + 1.2875 * 5% 0.094375 or 9.44% Present value of cash flows 2019 onwards = Free cash flows in 2019 / (required rate of return - growth rate) = 21.84/(0.094375 - 0.04) 401.6552 2015 2016 2017 2018 Free cash flows 14 24.5 19.25 21 Present Value of cash flows 2019 onwards 401.6552 Discount factor = (1/1.094375^year) 0.913764 0.834964 0.76296 0.697165 Present Value of free cash flows 12.79269 20.45661 14.68697 14.64046 free cash flow * discount factor Discount flow of PV of cash flows 2019 onwards 280.0198 Total Present Value of cash flows = 12.79269+20.45661+14.68697+14.64046+280.0198 342.5965 Value of Columbia to Martin $342.60 Million

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