Marston Marble Corporation is considering a merger with the Conroy Concrete Company. Conroy is a publicly traded company, and its beta is 1.30. Conroy has been barely profitable, so it has paid an average of only 20 percent in taxes during the last several years. In addition, it uses little debt, having a target ratio of just 25 percent, with the cost of debt 9 percent.
percent, with the cost of debt 9 percent. If the acquisition were made, Marston would operate Conroy as a separate, wholly owned subsidiary. Marston would pay taxes on a consolidated basis, and the tax rate would therefore increase to 35 percent. Marston also would increase the debt capitalization in the Conroy subsidiary to wd = 40% for a total of $22.27 million in debt by the end of Year 4, and pay 9.5 percent on the debt. Marston's acquisition department estimates that Conroy, if acquired, would generate the following free cash flows and interest expenses (in millions of dollars) in Years 1-5:
|
Year
|
Free Cash Flows
|
Interest Expense
|
|
1
|
$1.30
|
$1.2
|
|
2
|
1.50
|
1.7
|
|
3
|
1.75
|
2.8
|
|
4
|
2.00
|
2.1
|
|
5
|
2.12
|
?
|
In Year 5 Conroy's interest expense would be based on its beginning-of-year (that is, the end-of-Year-4) debt, and in subsequent years both interest expense and free cash flows are projected to grow at a rate of 6 percent.
These cash flows include all acquisition effects. Marston's cost of equity is 14 percent, its beta is 1.0, and its cost of debt is 10 percent. The risk-free rate is 6 percent, and the market risk premium is 4.5 percent.
a. What is the value of Conroy's unlevered operations and what is the value of Conroy's tax shields under the proposed merger and financing arrangements?
b. What is the dollar value of Conroy's operations? If Conroy has $10 million in debt outstanding, how much would Marston be willing to pay for Conroy?