# Question

Tech Giant Inc. (TGI) is evaluating a proposal to acquire Fusion Chips, a young company with an interesting new chip technology. This technology, when integrated into existing TGI silicon wafers, will enable TGI to offer chips with new capabilities to companies with automated manufacturing systems. TGI analysts have projected income statements for Fusion five years into the future. These projections appear in the following income statements, along with estimates of Fusion’s asset requirements and accounts payable balances each year. These statements are designed assuming that Fusion remains an independent, stand-alone company. If TGI acquires Fusion, analysts believe that the following changes will occur.

1. TGI’s superior manufacturing capabilities will enable Fusion to increase its gross margin on its existing products to 45 %.

2. TGI’s massive sales force will enable Fusion to increase sales of its existing products by 10 % above current projections (for example, if acquired, Fusion will sell $110 million, rather than $100 million, in 2012). This increase will occur as a consequence of regularly scheduled conversations between TGI salespeople and existing customers and will not require added marketing expenditures. Operating expenses as a percentage of sales will be the same each year as currently forecasted (ranges from 10% to 12%). The fixed asset increases currently projected through 2016 will be sufficient to sustain the 10 % increase in sales volume each year.

3. TGI’s more efficient receivables and inventory management systems will allow Fusion to increase its sales as previously described without making investments in receivables and inventory beyond those already reflected in the financial projection. TGI also enjoys a higher credit rating than Fusion, so after the acquisition, Fusion will obtain credit from suppliers on more favorable terms. Specifically, Fusion’s accounts payable balance will be 30 percent higher each year than the level currently forecast.

4. TGI’s current cash reserves are more than sufficient for the combined company, so Fusion’s existing cash balances will be reduced to $0.

5. Immediately after the acquisition, TGI will invest $50 million in fixed assets to manufacture a new chip that integrates Fusion’s technology into one of TGI’s best-selling products. These assets will be depreciated on a straight-line basis for eight years. After five years, the new chip will be obsolete, and no additional sales will occur. The equipment will be sold at the end of year 5 for $1 million. Before depreciation and taxes, this new product will generate $20 million in (incremental) profits the first year, $30 million the second year, and $15 million in each of the next three years. TGI will have to invest $3 million in net working capital up front, all of which it will recover at the end of the project’s life.

6. Both companies face a tax rate of 34 %.

The 2011 figures represent the balances currently on Fusion’s balance sheet.

a. Calculate the cash flows generated by Fusion as a stand-alone entity in each year from 2012 to 2016.

b. Assume that by 2016, Fusion reaches a “steady state,” which means that its cash flows will grow by 5% per year in perpetuity. If Fusion discounts cash flows at 15%, what is the present value as of the end of 2016 of all cash flows that Fusion will generate from 2017 forward?

c. Calculate the present value as of 2011 of Fusion’s cash flows from 2012 forward. What does this NPV represent?

d. Suppose TGI acquires Fusion. Recalculate Fusion’s cash flows from 2012 to 2016, making all the changes previously described in items 1–4 and 6.

e. Assume that after 2016 Fusion’s cash flows will grow at a steady 5 percent per year. Calculate the present value of these cash flows as of 2016 if the discount rate is 15%.

f. Ignoring item 5 in the list of changes, what is the PV as of 2011 of Fusion’s cash flows from 2012 forward? Use a discount rate of 15%.

g. Finally, calculate the NPV of TGI’s investment to integrate its technology with Fusion’s. Considering this in combination with your answer to part (f), what is the maximum price that TGI should pay for Fusion? Assume a discount rate of 15%.

1. TGI’s superior manufacturing capabilities will enable Fusion to increase its gross margin on its existing products to 45 %.

2. TGI’s massive sales force will enable Fusion to increase sales of its existing products by 10 % above current projections (for example, if acquired, Fusion will sell $110 million, rather than $100 million, in 2012). This increase will occur as a consequence of regularly scheduled conversations between TGI salespeople and existing customers and will not require added marketing expenditures. Operating expenses as a percentage of sales will be the same each year as currently forecasted (ranges from 10% to 12%). The fixed asset increases currently projected through 2016 will be sufficient to sustain the 10 % increase in sales volume each year.

3. TGI’s more efficient receivables and inventory management systems will allow Fusion to increase its sales as previously described without making investments in receivables and inventory beyond those already reflected in the financial projection. TGI also enjoys a higher credit rating than Fusion, so after the acquisition, Fusion will obtain credit from suppliers on more favorable terms. Specifically, Fusion’s accounts payable balance will be 30 percent higher each year than the level currently forecast.

4. TGI’s current cash reserves are more than sufficient for the combined company, so Fusion’s existing cash balances will be reduced to $0.

5. Immediately after the acquisition, TGI will invest $50 million in fixed assets to manufacture a new chip that integrates Fusion’s technology into one of TGI’s best-selling products. These assets will be depreciated on a straight-line basis for eight years. After five years, the new chip will be obsolete, and no additional sales will occur. The equipment will be sold at the end of year 5 for $1 million. Before depreciation and taxes, this new product will generate $20 million in (incremental) profits the first year, $30 million the second year, and $15 million in each of the next three years. TGI will have to invest $3 million in net working capital up front, all of which it will recover at the end of the project’s life.

6. Both companies face a tax rate of 34 %.

The 2011 figures represent the balances currently on Fusion’s balance sheet.

a. Calculate the cash flows generated by Fusion as a stand-alone entity in each year from 2012 to 2016.

b. Assume that by 2016, Fusion reaches a “steady state,” which means that its cash flows will grow by 5% per year in perpetuity. If Fusion discounts cash flows at 15%, what is the present value as of the end of 2016 of all cash flows that Fusion will generate from 2017 forward?

c. Calculate the present value as of 2011 of Fusion’s cash flows from 2012 forward. What does this NPV represent?

d. Suppose TGI acquires Fusion. Recalculate Fusion’s cash flows from 2012 to 2016, making all the changes previously described in items 1–4 and 6.

e. Assume that after 2016 Fusion’s cash flows will grow at a steady 5 percent per year. Calculate the present value of these cash flows as of 2016 if the discount rate is 15%.

f. Ignoring item 5 in the list of changes, what is the PV as of 2011 of Fusion’s cash flows from 2012 forward? Use a discount rate of 15%.

g. Finally, calculate the NPV of TGI’s investment to integrate its technology with Fusion’s. Considering this in combination with your answer to part (f), what is the maximum price that TGI should pay for Fusion? Assume a discount rate of 15%.

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