Problem 21-6

Merger Analysis

TransWorld Communications Inc., a large telecommunications company, is evaluating the possible acquisition of Georgia Cable Company (GCC), a regional cable company. TransWorld's analysts project the following post-merger data for GCC (in thousand of dollars):

2015	2016	2017	2018
Net Sales	$403	$487	$527	$580
Selling and administrative expense	41	51	56	66
Interest	18	21	24	27
Tax rate after merger	40%
Cost of goods sold as a percent of sales	65%
Beta after merger	1.70
Risk-free rate	6%
Market risk premium	3%
Continuing growth rate of cash flow available to TransWorld	5%

If the acquisition is made, it will occur on January 1, 2015. All cash flows shown in the income statements are assumed to occur at the end of the year. GCC currently has a capital structure of 40% debt, but Trans World would increase that to 50% if the acquisition were made. GCC, if independent, would pay taxes at 20%; but its income would be taxed at 40% if it were consolidated. GCC's current market-determined beta is 1.6, and its investment bankers think that its beta will rise to 1.7 if the debt ratio were increased to 50%. The cost of goods sold is expected to be 65% of sales, but could vary somewhat. Depreciation-generated funds would be used to replace worn-out equipment, so they would not be available to TransWorld's shareholders. The risk-free rate is 6%, and the market risk premium is 3%. Do not round intermediate calculations.

1. What is the appropriate discount rate for valuing the acquisition? % (to 2 decimals)
2. What is the continuing value? $ thousand (to 1 decimal)
3. What is the value of GCC to TransWorld? $ thousand (to 1 decimal)