Avco is a manufacturer of custom packaging products. Avco pays a corporate tax rate of 40%. Avco’s current market value balance sheet, with the associated cost of capital for boith its equity and debt is shown in the table below; Avco’s Current Market Value Balance Sheet ($ million) and cost of capital Assets Liabilities
Avco’s Current Market Value Balance Sheet ($ million)
Cash 20
Assets 600
Total 620
Debt 320
Equity 300
Total 620
Equity 10 %
Debt 6%
Suppose Avco is considering the acquisition of another firm in its industry that specializes in custom packing. The acquisition is expected to increase Avco’s free cash flow by $3.8 million the first year, and this contribution is expected to grow at a rate of 3% per year from then on. Avco has negotiated a purchase price of $80 million. After the transaction, Avco will adjust its capital structure to maintain its current debt-equity ratio. Required:
(a) If the acquisition has similar risk to the rest of Avco, what is the value of this deal?
(b) Suppose Avco proceeds with the acquisition described above. How much debt must Avco use to finance the acquisition and still maintain in debt-to-value ratio? How much of the acquisition cost must be financed with equity?
(c) Assume that the acquisition will be initially financed by $50 million in new debt. Compute the value of the acquisition using the Adjusted Present Value (APV) method, assuming Avco will maintain a constant debt-equity ratio for the acquisition.
(d) Assume that the acquisition will initially be financed by $50 million in new debt. What is the value of the acquisition using the Flows to Equity (FTE) method?