question archive The Los Angeles Corporation is viewed as a possible takeover target by California, Inc
The Los Angeles Corporation is viewed as a possible takeover target by California, Inc
Subject:FinancePrice:2.86 Bought22
The Los Angeles Corporation is viewed as a possible takeover target by California, Inc. Currently Los Angeles uses 10 percent debt in its capital structure, but California plans to increase the debt ratio to 50 percent if the acquisition is consummated. After-tax cost of debt capital for Los Angeles is estimated to be 15 percent, which holds constant under either capital structure. The cost of equity of Los Angeles after acquisition is expected to be 25 percent. The current market value of Los Angeles's outstanding debt is $ 20 million, all of which will be assumed by California. California intends to pay $ 80 million in cash and common stock for all Los Angeles's stock in addition to assuming all Los Angeles's debt. Currently, the market price of Los Angeles's common stock is $ 60 million. Selected items from Los Angeles's financial data are as follows: (millions) 2021 2022 2023 2024 Thereafter Net Sales $140.0 $161.0 $185.2 $212.9 $244.9 Administrative and selling expenses (S.G.A.) $10.0 $10.0 $15.0 $15.0 $20.0 Depreciation $5.0 $8.0 $10.0 $12.0 $15.0 $20 $22 $25 Capital expenditure (C.A.P.E.X.) $28 $30 In addition, the cost of goods sold (C.O.G.S.) runs 65 percent of sales and the marginal tax rate is 25 percent.
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We will first compute the free cash flows to the firm as = EBIT x (1 - tax rate) + Depreciation - Capital expenditure.
Please see the table below. All financials are in $ million. Please see the second row / column to understand the mathematics.
| Parameter | Linkage | 2021 | 2022 | 2023 | 2024 | Thereafter |
| Net Sales | A | 140.00 | 161.00 | 185.20 | 212.90 | 244.90 |
| [-] Cost of goods sold | B = 65% x A | 91.00 | 104.65 | 120.38 | 138.39 | 159.19 |
| [-] S.G.A expenses | C | 10.00 | 10.00 | 15.00 | 15.00 | 20.00 |
| [-] Depreciation | D | 5.00 | 8.00 | 10.00 | 12.00 | 15.00 |
| EBIT | E = A - B - C - D | 34.00 | 38.35 | 39.82 | 47.52 | 50.72 |
| Tax rate | T | 25% | 25% | 25% | 25% | 25% |
| CAPEX | F | 20.00 | 22.00 | 25.00 | 28.00 | 30.00 |
| Free cash flows | E x ( 1 - T) + D - F | 10.50 | 14.76 | 14.87 | 19.64 | 23.04 |
We will now calculate, r = weighted average cost of capital = Proportion of debt in capital structure after acquisition x After tax cost of debt + Proportion of equity in capital structure after acquisition x Cost of equity = 50% x 15% + 50% x 25% = 20%
From the free cash flow for the year after 2024, say C2025, we will calculate the terminal value, at the end of year 2024, of the free cash flows from the year 2025 onward till eternity, as = TV2024 = C2025 / r = 23.04 / 20% = 115.18
We will now find the value of the firm = PV of all the free cash flows over the horizon period + PV of terminal value.
| Year, n | Linkage | 1 | 2 | 3 | 4 |
| Free cash flows | G | 10.50 | 14.76 | 14.87 | 19.64 |
| Terminal Value | H | 115.18 | |||
| PV factor | (1 + r)-n | 0.8333 | 0.6944 | 0.5787 | 0.4823 |
| PV of free cash flows | I = G x PV factor | 8.75 | 10.25 | 8.60 | 9.47 |
| PV of terminal value | J = H x PV factor | 55.55 | |||
| Value of the firm | Sum of all I's & J | 92.62 |
Value of the equity, E = Value of the firm - market value of the debt = 92.62 - 20 = 72.62
Consideration paid for equity, C0 = 80
Hence, NPV = - C0 + E = - 80 + 72.62 = - $ 7.38 million
