MINI CASE answers 10-22

MINI CASE answers 10-22 - MINI CASE Hager's Home Repair...

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MINI CASE Hager’s Home Repair Company, a regional hardware chain, which specializes in “do-it- yourself” materials and equipment rentals, is cash rich because of several consecutive good years. One of the alternative uses for the excess funds is an acquisition. Doug Zona, Hager’s treasurer and your boss, has been asked to place a value on a potential target, Lyons’ Lighting, a small chain which operates in an adjacent state, and he has enlisted your help. The table below indicates Zona’s estimates of Lyons’ earnings potential if it came under Hager’s management (in millions of dollars). The interest expense listed here includes the interest (1) on Lyons’ existing debt, which is $55 million at a rate of 9%, and (2) on new debt expected to be issued over time to help finance expansion within the new “L division,” the code name given to the target firm. If acquired, Lyons' Lighting will face a 40% tax rate. Security analysts estimate that Lyons’ beta is 1.3. The acquisition would not change Lyons’ capital structure. Zona realizes that Lyons’ Lighting also generates depreciation cash flows, all of which must be reinvested in the division to replace worn-out equipment. The net retentions in the table below are required reinvestment in addition to these depreciation cash flows. Zona estimates the risk-free rate to be 9 percent and the market risk premium to be 4 percent. He also estimates that free cash flows after 2008 will grow at a constant rate of 6 percent. Following are projections for sales and other items. 2005 2006 2007 2008 Net sales $60.0 $90.0 $112.5 $127.5 Cost of goods sold (60%) 36.0 54.0 67.5 76.5 Selling/administrative expense 4.5 6.0 7.5 9.0 Interest expense 5.0 6.5 6.5 7.0 Required net retentions 0.0 7.5 6.0 4.5 Hager’ management is new to the merger game, so Zona has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Zona has developed the following questions, which you must answer and then defend to Hager’s board. Mini Case: 25- 1
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a. Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax considerations, (2) risk reduction, (3) control, (4) purchase of assets at below-replacement cost, (5) synergy, and (6) globalization. In general, which of the reasons are economically justifiable? Which are not? Which fit the situation at hand? Explain. Answer : The economically justifiable rationales for mergers are synergy and tax consequences. Synergy occurs when the value of the combined firm exceeds the sum of the values of the firms taken separately. (if synergy exists, then the whole is greater than the sum of the parts, and hence synergy is also called the "2 + 2 = 5" effect.) A synergistic merger creates value, which must be apportioned between the stockholders of the merging companies. Synergy can arise from four sources: (1) operating economies of scale in management, production, marketing, or distribution;
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MINI CASE answers 10-22 - MINI CASE Hager's Home Repair...

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