This problem tests your understanding of the chapter appendix. A group of investors is intent on purchasing a publicly traded company and wants to estimate the highest price they can reasonably justify paying. The target company's equity beta is 1.20 and its debt-to-firm value ratio, measured using market values, is 60 percent. The in- vestors plan to improve the target's cash flows and sell it for 12 times free cash flow in year 5. Projected free cash flows and selling price are as follows.
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Year
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1 2 3 4 5
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Free cash flows
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$25 $40 $45 $50 $50
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Selling price
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$600
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Total free cash flows
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$25 $40 $45 $50 $650
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To finance the purchase, the investors have negotiated a $400 million, five-year loan at 8 percent interest to be repaid in five equal pay- ments at the end of each year, plus interest on the declining balance. This will be the only interest-bearing debt outstanding after the acquisition
Selected Additional Information
Tax rate 40 percent
Risk free interest rate 3 percent
Market risk premium 5 percent
a. Estimate the target firm's asset beta.
b. Estimate the target's unlevered, or all-equity, cost of capital (KA).
c. Estimate the target's all-equity present value.
d. Estimate the present value of the interest-tax shields on the acqui- sition debt discounted at KA.
e. What is the highest price the investors can reasonably justify paying for the target company?
f. What does your estimated maximum acquisition price in question (e) assume about the costs of financial distress?