You own stock in Carpet City, Inc., which has just made a bid of $165 million to purchase Tile Corporation. The two firms currently have cumulative total cash flows of $25 million which are growing at 2 percent annually. Managers estimate that because of synergies the merged firm's cash flows will increase to 4 percent for the first three years following the merger. After the first three years cash flows will grow at a rate of 3 percent. The merged firms are expected to have a beta = 1.75, the risk-free rate is 5.5 percent, and the market risk premium is currently 7.5 percent. Calculate the NPV of the merger. Will you vote in favor of the merger?
A) Yes, the NPV is ≥ $0
B) Yes, the NPV is ≤ $0
C) No, the NPV is ≥ $0
D) No, the NPV is ≤ $0

Question

Quizplus · Accepted Answer

The NPV of the merger is calculated using the formula for the present value of growing perpetuity for the cash flows, adjusted for the synergies and growth rates post-merger, and incorporating the cost of equity derived from the CAPM model (Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium). Given the positive growth rates and the synergies expected from the merger, the cash flows are expected to increase, leading to a positive NPV when discounted at the appropriate cost of equity. Since the NPV is positive, it indicates that the merger adds value to the shareholders, and thus, voting in favor of the merger is the financially rational choice.

You Own Stock in Carpet City, Inc