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**Unformatted text preview: **, for $1 discounted at 11%
percent for the corresponding year obtained from Table A–2.
cWhen we use a financial calculator, we get a net present value of
$3,063. similar to those used in estimating capital budgeting cash flows. Typically, pro
forma income statements reflecting the postmerger revenues and costs attributable to the target company are prepared (see Chapter 3). They are then adjusted
to reflect the expected cash flows over the relevant time period. Whenever a firm
considers acquiring a target company that has different risk behaviors, it should
adjust the cost of capital appropriately before applying the appropriate capital
budgeting techniques (see Chapter 10).
EXAMPLE Square Company, a major media company, is contemplating the acquisition of
Circle Company, a small independent film producer that can be purchased for
$60,000. Square currently has a high degree of financial leverage, which is
reflected in its 13% cost of capital. Because of the low financial leverage of Circle
Company, Square estimates that its overall cost of capital will drop to 10% after
the acquisition. Because the effect of the less risky capital structure cannot be
reflected in the expected cash flows, the postmerger cost of capital (10%) must be
used to evaluate the cash flows that are expected from the acquisition. The postmerger cash flows attributable to the target company are forecast over a 30-year
time horizon. These estimated cash flows (all inflows) and the resulting net present value of the target company, Circle Company, are shown in Table 17.3.
Because the $2,357 net present value of the target company is greater than
zero, the merger is acceptable. Note that if the effect of the changed capital structure on the cost of capital had not been considered, the acquisition would have
been found unacceptable, because the net present value at a 13% cost of capital is
negative $11,864 (or $11,868 using a financial calculator). CHAPTER 17 Mergers, LBOs, Divestitures, and Business Failure TABLE 17.3 723 Net Present Value of the
Circle Company Acquisition Year(s) Cash inflows
(1) Present value
factor at 10%a
(2) Present value
[(1) (2)]
(3) 11–10 $ 5,000 6.145 $30,725 11–18 13,000 (8.201 6.145)b 19–30 4,000 (9.427 8.201)b Present value of inflows
Less: Cash purchase price
Net present valuec 26,728
4,904
$62,357
60,000
$ 2,357 aPresent value interest factors for annuities, PVIFA, obtained from
Table A–4.
bThese factors are found by using a shortcut technique that can be
applied to annuities for periods of years beginning at some point in the
future. By finding the appropriate interest factor for the present value
of an annuity given for the last year of the annuity and subtracting the
present value interest factor of an annuity for the year immediately preceding the beginning of the annuity, the appropriate interest factor for
the present value of an annuity beginning sometime in the future can be
obtained. You can check this shortcut by using the long approach and
comparing the results.
cWhen we use a financial calculator, we get a net present value of
$2,364. Stock Swap Transactions stock swap trans...

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