Avco is a manufacturer of custom packaging products. Avco pays a corporate tax r
ID: 2803754 • Letter: A
Question
Avco is a manufacturer of custom packaging products. Avco pays a corporate tax rate of 40%. Avco’s current market value balance sheet, with the associated cost of capital for boith its equity and debt is shown in the table below; Avco’s Current Market Value Balance Sheet ($ million) and cost of capital Assets Liabilities
Avco’s Current Market Value Balance Sheet ($ million)
Cash 20
Assets 600
Total 620
Debt 320
Equity 300
Total 620
Equity 10 %
Debt 6%
Suppose Avco is considering the acquisition of another firm in its industry that specializes in custom packing. The acquisition is expected to increase Avco’s free cash flow by $3.8 million the first year, and this contribution is expected to grow at a rate of 3% per year from then on. Avco has negotiated a purchase price of $80 million. After the transaction, Avco will adjust its capital structure to maintain its current debt-equity ratio. Required:
(a) If the acquisition has similar risk to the rest of Avco, what is the value of this deal? (6 marks)
(b) Suppose Avco proceeds with the acquisition described above. How much debt must Avco use to finance the acquisition and still maintain in debt-to-value ratio? How much of the acquisition cost must be financed with equity?
(c) Assume that the acquisition will be initially financed by $50 million in new debt. Compute the value of the acquisition using the Adjusted Present Value (APV) method, assuming Avco will maintain a constant debt-equity ratio for the acquisition. (7 marks)
(d) Assume that the acquisition will initially be financed by $50 million in new debt. What is the value of the acquisition using the Flows to Equity (FTE) method? (6 m)
Explanation / Answer
1a)
Assets
Liabilities
Cash
20
Debt
320
Assets
600
Equities
300
Total
620
Total
620
Note: Net Debt is 320-20=300
WACC = rd×(1-Tc)×(D/E+D)+re×(E/E+D)
Where rd=Cost of debt=6%
Tc=Tax Rate=40%
D/E+D=Proportion of debt in the firm=(300/600)=0.50
re=Cost of Equity=10%
E/E+D= Proportion of equity in the firm=(300/600)=0.50
WACC= 6(1-0.40)(0.50)+10(0.50)
=6.8%
The free cash flow of the acquisition can be valued as a growing perpetuity at the rate of 3%. Since, AVCO will maintain the same discount rate going forward we can discount these cash flows at a rate 6.8%
Therefore, value of acquisition:
VL=3.80/(0.0680-0.03)
= $ 100 Mn
Given the purchase price f $ 80 Mn, the NPV= 100-80=$ 20 Mn
1b) The value of the acquisition is $ 100 Mn
To maintain the same debt to value ratio (0.50), AVCO must increase its debt by $ 50 Mn
The remaining $ 30 Mn of $ 80 Mn must be financed with equity.
In addition NPV of $ 20 Mn of the project will increase AVCO’s equity market value to increase in total by $ 50 Mn (30+20).
1c) APV (VL) = Vu+ PV(Interest Tax Shield)
The formula to calculate the cost of capital for a firm if it is unlevered:
WACC=rd×(D/E+D)+re×(E/E+D)
=0.50×6+0.50×10
=8%
Vu=3.8/(0.08-0.03)=$ 76 Mn
Avco will add new debt of $ 50 Mn. At 6% interest rate, the first year interest expense is 6 % of $ 50 Mn=$ 3 Mn. The $ 3 Mn interest expense provides a tax shield of 40 % of $ 3Mn= $ 1.2 Mn. Since value of acquisition will grow by 3%, value of interest expense will also grow by 3% .
Therefore, PV of interest tax shield is: 1.2/(0.08-0.03)=$ 24 Mn
Therefore value of acquisition using APV= 76+24=$ 100 Mn
Thus, the NPV of the project is still $ 20 Mn (100-80).Without the benefit of tax shield, the NPV of the project will be -$ 4Mn (76-80).
1d) Because the acquisition is being financed with $ 50 Mn debt, the remaining $ 30 Mn must come from equity.
FCFE0= -80+50= - $ 30 Mn
Interest cost on debt will be: 0.06×50=$ 3 Mn
As AVCO will maintain a constant debt to equity ratio, the debt associated with acquisition will grow at a rate of 3 % to 50×1.03= $ 51.5 Mn.
Therefore, additional debt in one year time will be :51.5-50 =$ 1.5 Mn
FCFE1=+3.80-(1-0.40)×3+1.50= $ 3.5 Mn
After 1 year FCFE will grow at a rate of 3 %. Using cost of equity as 10 % the NPV of the project will be:
-30+3.50/(0.10-0.03)
=$ 20 Mn
Assets
Liabilities
Cash
20
Debt
320
Assets
600
Equities
300
Total
620
Total
620
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.