Company Bigger is thinking about buying a small startup company, Tinyer, from the founders. You have the following information:

Bigger has a debt-to-equity ratio (leverage) of 2, the covariance of its equity return with the market return is 0.09.

The riskfree rate is 0.03, the expected market return is 0.08 and the standard deviation of the market return is 0.2.

The corporate tax rate is 0.4.

Both Bigger and Tinyer are selling widgets, and you can assume that they have the same business risk.

Each year Tinyer sells 200,000 units of widgets. The expected sales price for each unit is 15 and the variable cost for each unit is 5. In addition, Tinyer has an expected annual fixed cost of 500,000.

You can assume that both the existing operations of Bigger and the income stream of Tinyer are perpetual.

There are no frictions, no bankruptcy costs, markets are efficient and CAPM holds.

1. Assume that Bigger plans to use only equity to finance the buyout of Tinyer. What is the maximum value that Bigger is willing to pay for Tinyer?

2. Now assume that Bigger can partially finance the buyout using riskfree debt. The perpetual debt it would issue would have annual coupons of 40,000. What is the maximum price it is willing to pay for Tinyer in this scenario?

Answer rating: 100% (QA)

Biggers Acquisition of Tinyer 1 Equity Financing a Tinyers Unlevered Value Operating Profit Before T... View the full answer