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BTR Warehousing, which is considering the acquiition of Galaxy Sun Corp., estimates that acquiring Galaxy Sun will result in an incremental value for the firm. The analysts involved in the deal have collected the following information from the projected financial statements of the target company:

Data collected (in millions of dollars)

Year 1 Year 2 Year 3
EBIT $14.0 $16.8 $21.0
Interest Expense 4.0 4.4 4.8
Debt 31.9 37.7 40.6
Total net operating capital 121.5 123.9 126.3

Galaxy Sun Corp. is a publicly traded company, and its market-determined pre-merger beta is 1.20. You also have the following information about the company and the projected statements:

a) Galaxy Sun currently has a $32.00 million market value of equity and $ 20.80 million in debt.

b) The risk-free rate is 4%, there is a 6.10% market risk premium, and the capital aset pricing model purchases a pre-merger required rate of return on equity of 11.32%.

c) Galaxy Sun's cost of debt is 6.00% at a tax rate of 35%.

d) The projections assume that the company will have a post-horizon growth rate of 5.00%.

e) Current total net operating capital is $118.0, and the sum of existing debt and debt required to maintain a constant capital structure at the time of acquisitionis $29 million.

f) The firm does not have any nonoperating assets such as marketable securities.

Given this information, use the adjusted present value (APV) approach to calculate the following values involved in merger analysis:

1. Unlevered cost of equity: 8.10%/ 6.82% / 9.22% / 10.50%

2. Horizontal value of unlevered cash flows: $211.99 million / $279.92 million / $266.59 million / $132.70 million

3. Horizontal value of tax shield: $41.80 million / $39.81 million / $66.35 million / $38.32 million

4. Unlevered value of operations: $64.28 million / $233.62 million / $235.75 million / $228.61 million

5. Value of tax shield: $35.94 million / $74.66 million / $62.57 million / $39.65 million

6. Value of operations: $138.94 million / $271.69 million / $268.26 million / $296.19 million

7. Thus, the total value of Galaxy Sun's equity is $250.89 million / $214.95 million / $43.48 million / $275.39 million

8. Supposse BTR Warehousing plans to use more debt in the first few years of theacquisition of Galaxy Sun Corp. Assuming that using more debt will not lead to an increse in bankruptcy costs for BTR Warehousing, the interest tax shields and tha value of the tax shield in the analyssis, will decrease / increase, leading to a higher / lower value of operations of the acquired firm.

9. The APV approach is considered useful for valuing acquisition targets, because the method involves finding the values of the unlevered firm and the interest tax shield separately and then summing those values. Why is it difficult to value certain types of acquisitions using the corporate valuation model?

- The acquiring firm immediately retires the target firm's old debt. Thus, the acquisition deal consists of only new debt in its capital structure.

- The acquiring firm usually assumes the debt of the target firm. Thus, old debt with different coupon rates usually becomes a part of the aquisition deal.

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Deanna Hettinger
Deanna HettingerLv2
28 Sep 2019
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Consider the following acquisition data regarding Washington Company and Orators Telecom Inc.:

Washington Company is considering an acquisition of Orators Telecom Inc. Washington Company estimates that acquiring Orators will result in incremental value for the firm. The analysts involved in the deal have collected the following information from the projected financial statements of the target company.

Data Collected (in millions of Dollars)

Year 1 Year 2 Year 3
EBIT 12.0 14.4 18.0
Interest Expense 3.0 3.3 3.6
Debt 29.7 35.1 37.8
Total net operating capital 107.1 109.2 111.3

Orators is a publicly traded company, and its market-determined pre-merger beta is 1.00. You also have the following information about the company and the projected statements.

- Orators currently has a $16.00 million market value of equity and $10.40 million in debt.

- The risk-free rate is 5.5% with a 7.60% market risk premium, and the Capital Asset Pricing Model produces a pre-merger required rate of return on equity RsL of 13.10%.

- Orators's cost of debt is 7.50% at a tax rate of 35%.

- The projections assume that the company will have a post-horizon growth rate of 5.00%.

- Current total net operating capital is $104.0, and the sum of existing debt and debt required to maintain a constant capital structure at the time of acquisition is $27 million.

- The firm has no nonoperating assets, such as marketable securities.

With the given information, use the free cash flow to equity (FCFE) approach to calculate the following values involved in the merger analysis:

1. FCFE horizon value: $139.07 million / $129.75 million / $129.11 million / $146.75 million

2. Value of FCFE: $111.95 million / $39.60 million / $109.17 million / $125.77 million

3. The estimated value of Orators's operations after the merger is more / less than the market value of Orators's equity. This means that the wealth of Orators's shareholders will increase / decrease if it merges with Washington rather than remaining as a stand-alone corporation.

Please read the article and answer these THREE questions:

1. Why are conditions currently favorable for firms to issue debt and pay out the proceeds to stockholders?

2. What are dangerous impacts of issuing additional debt mentioned in the article?

3. TransDigm used the proceeds of their debt issue to pay a one-time dividend while Intel used the proceeds to repurchase shares. How does a repurchase differ from a one-time dividend? Why do you think the two firms chose different approaches to distributing cash to shareholders?

___________

"Borrowing for Dividends Raises Worries" at the Wall Street Journal on 10/06/2009

Rock-bottom interest rates and thawed credit markets are emboldening some companies to use bond-sale proceeds to go on the offensive, even if that means rewarding shareholders at the expense of bondholders.

The nascent trend is controversial because corporate borrowers are sinking themselves deeper into debt to pay out special dividends, buy back stock or finance acquisitions. While such moves were all the rage during the credit boom, most corporate-bond offerings during the recession have been used to reduce debt or stockpile cash.

Eric Felder, global head of credit trading at Barclays Capital, says the lure of low rates and companies' stables of cash increases "the risk of non-bondholder friendly events."

Last week's sale of $425 million of bonds by aircraft-parts manufacturer TransDigm Group Inc. is one of the back-to-the-past corporate-bond deals causing concern among some analysts. More than $360 million of the proceeds will be used to pay a special cash dividend to shareholders and management of the Cleveland company.

The added debt increased TransDigm's borrowings to 4.3 times its earnings before interest and taxes, compared with 3.1 times before last week's deal. The expected dividend of $7.50 to $7.70 a share is equal to nearly all of the net income that TransDigm reported since the end of fiscal 2003, according to Moody's Investors Service.

Moody's said the dividend "illustrates the company's aggressive financial policy." Moody's gave the new debt a junk rating of B3, even though the ratings firm said TransDigm's "strong operating performance will enable the company to service the increased debt level."

Sean Maroney, director of investor relations at TransDigm, says the "stability of our business, high profit margins and consistent cash flow" give the company "the ability to support this level of leverage."

Borrowing from bondholders to pay shareholder dividends is "a hallmark of an earlier credit era," Jeffrey Rosenberg, head of credit strategy at Bank of America Merrill Lynch, wrote in a report Friday. Such deals were popular in 2003 and 2004, the last time the Federal Reserve lowered its benchmark interest rate to historically low levels, keeping it at 1% for more than a year.

Companies like Dex Media Inc. DEX -0.18% took on debt to pay dividends to its private-equity owners, including Carlyle Group and Welsh, Carson, Anderson & Stowe, before taking the companies public. Dex Media filed for bankruptcy earlier this year under a mountain of debt.

With the federal-funds rate at 0% for nine months now and confidence returning to the stock and debt markets, investors have been driven to take on more risk. That is flooding the corporate-bond market with cash. Investors poured $43 billion into investment-grade corporate-bond funds in the second quarter and nearly $40 billion in the third quarter -- almost double previous peak quarters, according to Lipper AMG Data Services.

The wave of buying drove down borrowing costs for the average highly rated corporation to about 5%, according to Merrill, a level not seen since 2005. In the heat of the crisis last October, such rates averaged 9%. Through the end of September, more than 1,000 high-rated companies borrowed a record $860 billion, according to Dealogic.

In July, Intel Corp. INTC 0.33% sold $1.75 billion of convertible bonds, planning to use $1.5 billion of the proceeds to buy back shares. A spokesman for Intel declined to comment.

The computer-chip giant has a strong credit rating of single-A, so it doesn't carry a burdensome debt load. Still, the deal raised eyebrows among some analysts and investors, who say floating debt to buy back stock could become more common as companies regain confidence.

And as merger-and-acquisition activity revs up, the cheaper cost of debt compared with equity is tempting companies to use bond sales as a deal-making war chest.

Analysts are watching Kraft Foods Inc. in anticipation that the company would finance its proposed purchase of U.K. chocolate, candy and chewing gum maker Cadbury PLC by raising tons of debt. Last month's unsolicited bid by Kraft was then valued at about $16.7 billion, but it could be weeks before Kraft submits a formal offer.

Three major credit-ratings agencies have warned Kraft that they could slash the company's debt ratings if the company reaches a deal agreement with Cadbury. At the current offering price, Kraft would need to shell out at least $6 billion in cash, much of it likely from the debt markets, according to corporate-bond research firm Gimme Credit.

"Kraft is committed to maintaining an investment-grade rating," a Kraft spokesman said, declining to comment further.

So far in 2009, returns to high-grade bond investors are 19%, according to Merrill. "We've seen a feeding frenzy" because of low interest rates, says Kathleen Gaffney, portfolio manager at Loomis, Sayles & Co. She sold some bonds recently to take profits from the rally. Loomis Sayles wants to have cash on the sidelines in case the Fed raises rates soon or Treasury bonds sell off.

Please read the article and answer these THREE questions:

1. Why are conditions currently favorable for firms to issue debt and pay out the proceeds to stockholders?

2. What are dangerous impacts of issuing additional debt mentioned in the article?

3. TransDigm used the proceeds of their debt issue to pay a one-time dividend while Intel used the proceeds to repurchase shares. How does a repurchase differ from a one-time dividend? Why do you think the two firms chose different approaches to distributing cash to shareholders?

___________ "Borrowing for Dividends Raises Worries" at the Wall Street Journal on 10/06/2009

Rock-bottom interest rates and thawed credit markets are emboldening some companies to use bond-sale proceeds to go on the offensive, even if that means rewarding shareholders at the expense of bondholders. The nascent trend is controversial because corporate borrowers are sinking themselves deeper into debt to pay out special dividends, buy back stock or finance acquisitions. While such moves were all the rage during the credit boom, most corporate-bond offerings during the recession have been used to reduce debt or stockpile cash.

Eric Felder, global head of credit trading at Barclays Capital, says the lure of low rates and companies' stables of cash increases "the risk of non-bondholder friendly events." Last week's sale of $425 million of bonds by aircraft-parts manufacturer TransDigm Group Inc. is one of the back-to-the-past corporate-bond deals causing concern among some analysts. More than $360 million of the proceeds will be used to pay a special cash dividend to shareholders and management of the Cleveland company. The added debt increased TransDigm's borrowings to 4.3 times its earnings before interest and taxes, compared with 3.1 times before last week's deal. The expected dividend of $7.50 to $7.70 a share is equal to nearly all of the net income that TransDigm reported since the end of fiscal 2003, according to Moody's Investors Service. Moody's said the dividend "illustrates the company's aggressive financial policy." Moody's gave the new debt a junk rating of B3, even though the ratings firm said TransDigm's "strong operating performance will enable the company to service the increased debt level." Sean Maroney, director of investor relations at TransDigm, says the "stability of our business, high profit margins and consistent cash flow" give the company "the ability to support this level of leverage." Borrowing from bondholders to pay shareholder dividends is "a hallmark of an earlier credit era," Jeffrey Rosenberg, head of credit strategy at Bank of America Merrill Lynch, wrote in a report Friday. Such deals were popular in 2003 and 2004, the last time the Federal Reserve lowered its benchmark interest rate to historically low levels, keeping it at 1% for more than a year.

Companies like Dex Media Inc. DEX -0.18% took on debt to pay dividends to its private-equity owners, including Carlyle Group and Welsh, Carson, Anderson & Stowe, before taking the companies public. Dex Media filed for bankruptcy earlier this year under a mountain of debt. With the federal-funds rate at 0% for nine months now and confidence returning to the stock and debt markets, investors have been driven to take on more risk. That is flooding the corporate-bond market with cash. Investors poured $43 billion into investment-grade corporate-bond funds in the second quarter and nearly $40 billion in the third quarter -- almost double previous peak quarters, according to Lipper AMG Data Services. The wave of buying drove down borrowing costs for the average highly rated corporation to about 5%, according to Merrill, a level not seen since 2005. In the heat of the crisis last October, such rates averaged 9%. Through the end of September, more than 1,000 high-rated companies borrowed a record $860 billion, according to Dealogic. In July, Intel Corp. INTC 0.33% sold $1.75 billion of convertible bonds, planning to use $1.5 billion of the proceeds to buy back shares. A spokesman for Intel declined to comment. The computer-chip giant has a strong credit rating of single-A, so it doesn't carry a burdensome debt load. Still, the deal raised eyebrows among some analysts and investors, who say floating debt to buy back stock could become more common as companies regain confidence. And as merger-and-acquisition activity revs up, the cheaper cost of debt compared with equity is tempting companies to use bond sales as a deal-making war chest. Analysts are watching Kraft Foods Inc. in anticipation that the company would finance its proposed purchase of U.K. chocolate, candy and chewing gum maker Cadbury PLC by raising tons of debt. Last month's unsolicited bid by Kraft was then valued at about $16.7 billion, but it could be weeks before Kraft submits a formal offer.

Three major credit-ratings agencies have warned Kraft that they could slash the company's debt ratings if the company reaches a deal agreement with Cadbury. At the current offering price, Kraft would need to shell out at least $6 billion in cash, much of it likely from the debt markets, according to corporate-bond research firm Gimme Credit. "Kraft is committed to maintaining an investment-grade rating," a Kraft spokesman said, declining to comment further. So far in 2009, returns to high-grade bond investors are 19%, according to Merrill. "We've seen a feeding frenzy" because of low interest rates, says Kathleen Gaffney, portfolio manager at Loomis, Sayles & Co. She sold some bonds recently to take profits from the rally. Loomis Sayles wants to have cash on the sidelines in case the Fed raises rates soon or Treasury bonds sell off.

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