22. A group of investors is intent on purchasing a publicly traded company and wants to...

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22. A group of investors is intent on purchasing a publicly traded company and wants to estimate the highest price they can reasonably justify paying. The target company's equity beta is 1.20 and its debt-to-firm value ratio, measured using market values, is 60 percent. The investors plan to improve the target's cash flows and sell it for 12 times free cash flow in year 5. Projected free cash flows and selling price are as follows. Year 1 2 ($ millions) 3 4 5 Free cash flows Selling price $25 $40 $45 $50 $ 50 $600 Total free cash flows $25 $40 $45 $50 $650 To finance the purchase, the investors have negotiated a $400 million, five-year loan at 8 percent interest to be repaid in five equal payments at the end of each year, plus interest on the declining balance. This will be the only interest-bearing debt outstanding after the acquisition. Tax rate Selected Additional Information 40 percent 3 percent 5 percent Risk-free interest rate Market risk premium a. Estimate the target firm's asset beta. b. Estimate the target's unlevered, or all-equity, cost of capital (KA). c. Estimate the target's all-equity present value. d. Estimate the present value of the interest tax shields on the acquisition debt discounted at K. e. What is the highest price the investors can reasonably justify paying for the target company? f. What does your estimated maximum acquisition price in question (e) assume about the costs of financial distress? page 333 22. A group of investors is intent on purchasing a publicly traded company and wants to estimate the highest price they can reasonably justify paying. The target company's equity beta is 1.20 and its debt-to-firm value ratio, measured using market values, is 60 percent. The investors plan to improve the target's cash flows and sell it for 12 times free cash flow in year 5. Projected free cash flows and selling price are as follows. Year 1 2 ($ millions) 3 4 5 Free cash flows Selling price $25 $40 $45 $50 $ 50 $600 Total free cash flows $25 $40 $45 $50 $650 To finance the purchase, the investors have negotiated a $400 million, five-year loan at 8 percent interest to be repaid in five equal payments at the end of each year, plus interest on the declining balance. This will be the only interest-bearing debt outstanding after the acquisition. Tax rate Selected Additional Information 40 percent 3 percent 5 percent Risk-free interest rate Market risk premium a. Estimate the target firm's asset beta. b. Estimate the target's unlevered, or all-equity, cost of capital (KA). c. Estimate the target's all-equity present value. d. Estimate the present value of the interest tax shields on the acquisition debt discounted at K. e. What is the highest price the investors can reasonably justify paying for the target company? f. What does your estimated maximum acquisition price in question (e) assume about the costs of financial distress? page 333