Question: The Huge Co. , a conglomerate, is negotiating a takeover of the Tiny Co. and is using discounted cash-flow analysis to establish an appropriate value. Tiny would be the tenth small firm taken over in the past 15 months. Huge currently has a cost of capital of 20 percent, a tax rate of 40 percent, and, because it is so much larger than Tiny, expects that there is no need to reevaluate its cost of capital after the takeover. Estimates of annual after-tax cash flows from operations for Tiny are: years 1 to 5: $20,000 in year 1, increasing by $5,000 annually years 6 to 10: $40,000 each year In addition, new equipment will have to be bought in year 5 at a cost of $50,000. Capital cost allowances on this equipment will amount to $5,000 in the first year and 20 percent on the declining balance thereafter. Furthermore, in year 6, a $6,000 investment in working capital will be called for. These cash flows are not included in the operating projections given above. The estimated market value of Tiny at the end of year 1 0, net of taxes on recaptured depreciation and capital gains is $ 100,000. Tiny has no senior securities in its capital structure, and its cost of capital is estimated to be 28 percent.
(a) What is the maximum cash offer that Huge should make for the firm?
(b) If Tiny's assets include excess cash of $ 1 5,000 that is temporarily invested in Government of Canada paper, how would this alter your response under part (a) above?
(c) If Tiny had unused borrowing capacity, how might this alter your analysis? Briefly discuss and illustrate.