A sporting goods manufacturer has decided to expand into a related business. Management estimates that to build and staff a facility of the desired size and to attain capacity operations would cost 450 million in present value terms. Alternatively, the company could acquire an existing firm or division with the desired capacity. One such opportunity is the division of another company. The book value of the division's assets is 250 million and its earnings before taxes and tax are presently 50 million. Publicly traded comparable companies are selling in a narrow range around 12 times current earnings. These companies have book value debt to asset ratios averaging 40 percent with an average interest rate of 10 percent.
Referring to the 450 million price tag as the replacement value of the division, what would you predict would happen to acquisition activity when market values of companies and divisions rise above their replacement values? The tax rate is 34%.