1. You are analyzing an acquisition using either 100% debt or 100% equity as the only two financing solutions. You perform an analysis of capital sources and the impact on the firm's earnings for the $3 billion deal. ABC Inc. currently has 800 million shares outstanding and a market price of $50 per share. The firm has a cost of debt (before tax) of 7 percent. The target firm has $800 million in debt carrying a 12% rate that will be assumed by ABC Inc. You run an analysis that includes a five-year projection for the combined company to determine EBIT in Table 3. Using either all equity ($50 issuance price) or all debt (7%) to buy Target Co., assuming no flotation costs in this model, and assuming 30% tax rate, when is the deal accretive to earnings and how should the firm finance the acquisition?
Table 3. Combined projection of EBIT for ABC Inc and Target Company & EPS for ABC Alone Without Acquisition.
Combined Without Acquisition
EBIT ABC Inc EPS
Year 0 4,500,000,000 $2.75
Year 1 4,455,000,000 $2.97
Year 2 4,722,300,000 $3.21
Year 3 5,194,530,000 $3.46
Year 4 5,713,983,000 $3.74
Year 5 6,171,101,640 $4.04
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