Question 1

regional restaurant chain, Club Café, is considering purchasing a smaller chain, Sally's Sandwiches, which is currently financed using 20% debt at a cost of 8% Club Café's analysts project that the merger will result in incremental free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4 (The Year 4 cash flow includes a horizon value of $107 million.) The acquisition would be made immediately, if it is to be undertaken Sally's pre-merger beta is 2.0, and its post-merger tax rate would be 34% The risk-free rate is 8%, and the market risk premium is 4% What is the appropriate rate for use in discounting the free cash flows and the interest tax savings?

Accepted Answer

The appropriate rate for use in discounting the free cash flows and the interest tax savings is the weighted average cost of capital (WACC). The WACC is calculated as follows:WACC = (E/V) * Re + (D/V) * Rd * (1 - T)where:E = market value of equityV = total value of the firmRe = cost of equityD = market value of debtRd = cost of debtT = tax rateIn this case, we are given the following information:E/V = 80%D/V = 20%Re = 12%Rd = 8%T = 34%Plugging these values into the WACC formula, we get:WACC = (0.80) * 0.12 + (0.20) * 0.08 * (1 - 0.34) = 0.144 or 14.4%Therefore, the appropriate rate for use in discounting the free cash flows and the interest tax savings is 14.4%.

Question 2

parent holding company sells shares in its subsidiary such that the parent now owns only 65% of the subsidiary and, thus, the tax returns of the parent and its subsidiary can't be consolidated The parent receives annual dividends from the subsidiary of $2,500,000 If the parent's marginal tax rate is 34% and if the exclusion on intercompany dividends is 70%, what is the effective tax rate on the intercompany dividends, and how much net dividends are received?

Accepted Answer

First, we need to calculate the exclusion of intercompany dividends. The exclusion is 70%, so the taxable amount of the dividends is $2,500,000 * (1-70%) = $750,000.
Then, we need to calculate the tax on the dividends. The parent's marginal tax rate is 34%, so the tax on $750,000 is $255,000.
So, the effective tax rate on the intercompany dividends is $255,000 / $2,500,000 = 10.2%.
Finally, we need to calculate the net dividends received by the parent. The total dividends received are $2,500,000, but the taxable amount is $750,000. So, the net dividends received are $2,500,000 - $750,000 = $1,750,000.
Therefore, the answer is A) 10.2%; $2,245,000.

Question 3

Which of the following statements is most CORRECT?

Accepted Answer

The statement in choice C is the most correct because it accurately reflects a commonly held belief that diversification benefits are not a valid motive for publicly held firms since shareholders can diversify their own holdings. The other statements contain inaccuracies. Choice A suggests that a lack of synergistic benefits is a positive factor in mergers, while in reality, synergistic benefits are typically seen as a positive factor. Choice B is inaccurate because the cost of debt and debt capacity are important considerations for mergers financed by debt. Choice D is incorrect because operating economies, such as cost savings and increased efficiency, are commonly cited as motives for mergers. Choice E is also inaccurate because tax considerations can often be a factor in mergers, and the statement that firms with excess cash rarely undertake mergers is a generalized oversimplification.

Question 4

rate used to discount projected merger cash flows should be the cost of capital of the new consolidated firm because it incorporates the actual capital structure of the new firm.

Accepted Answer

The answer of rate used to discount projected merger cash...

Question 5

Which of the following statements about valuing a firm using the APV approach is most CORRECT?

Accepted Answer

The APV approach involves valuing the operations (or assets) separately from the financing side (or liabilities and equity). The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows before the horizon date at the unlevered cost of equity. The value of equity is then found by adding the present value of the tax shields and adjusting for the market value of the debt. Therefore, statement B is most correct as it correctly identifies the valuation of operations in the APV approach.

Question 6

Although goodwill created in a merger may not be amortized for shareholder reporting purposes, it may be amortized for Federal tax purposes.

Accepted Answer

According to the rules set by the IRS, goodwill created in a merger may be amortized for Federal tax purposes over a period of 15 years.

Question 7

Which of the following statements about valuing a firm using the APV approach is most CORRECT?

Accepted Answer

In the APV approach, the horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the weighted average cost of capital (WACC). This is because the horizon value represents the present value of future cash flows beyond the projection period, and the WACC represents the appropriate required return on those cash flows. Therefore, choice C is the most correct statement. Choice A is incorrect because the tax savings should be discounted at the cost of equity, not the cost of debt. Choice B is incorrect because it suggests that the horizon value is based solely on earnings, while it should be based on free cash flows. Choice D is incorrect because the appropriate horizon time period depends on the circumstances of the firm and the industry, and there is no universally applicable minimum or maximum horizon value. Choice E is incorrect because the levered cost of equity is not necessarily the appropriate discount rate for the horizon value.

Question 8

Discounted cash flow methods are not appropriate for evaluating mergers because the cash flows are uncertain and the discount rate can only be determined after the merger is consummated.

Accepted Answer

Discounted cash flow methods are commonly used for evaluating mergers, despite the uncertainty of cash flows and the need for assumptions to determine the discount rate. These methods can provide valuable insights into the potential profitability of a merger and are commonly used by financial analysts and investment bankers.

Question 9

a financial merger, the relevant post-merger cash flows are simply the sum of the expected cash flows of the 2 companies, measured as if they were operated independently.

Accepted Answer

The cash flows of the two companies are not affected by the merger, so the sum of the expected cash flows of the two companies is the same as the expected cash flows of the merged company.

Question 10

Since a manager's central goal is to maximize the firm's stock price, any merger offer that provides stockholders with significant gains over the current stock price will be approved by the current management team.

Accepted Answer

While maximizing the firm's stock price is a central goal, management may reject merger offers that provide significant gains if they believe the merger is not in the long-term best interest of the company, or if it threatens their job security or control over the firm.

Question 11

the capital structure is stable, and free cash flows are expected to be growing at a constant rate at the horizon date, then the horizon value is calculated by discounting the free cash flows plus the expected future tax shields at the weighted average cost of capital.

Accepted Answer

The answer of the capital structure is stable, and free...

Question 12

3 main advantages of holding companies are (1) control with fractional ownership, (2) taxation benefits, and (3) isolation of operating risks.

Accepted Answer

The answer of 3 main advantages of holding companies are...

Question 13

Which of the following statements is most CORRECT?

Accepted Answer

Operating mergers are those in which two firms are in the same or related lines of business, and the primary rationale for such mergers is synergy, i.e., the potential for increased efficiency and profitability through shared resources, technology, expertise, and market access. Financial mergers, by contrast, involve firms in different lines of business and are motivated by financial engineering, such as tax savings, diversification, or economies of scale in financing. The other statements are either partially or wholly incorrect. For instance, A) is incorrect because the method of payment can affect the cost of capital and the risk profile of the firm, and thus, its valuation and shareholder value; B) is incorrect because the estimation of proforma cash flows is relevant but not necessarily the most important part of the analysis, which also includes the selection of the target, the negotiation of the terms, and the assessment of the risks and benefits of the merger; C) is incorrect because the benefits of a merger cannot be assumed to be equally distributed, and oftentimes, the target shareholders receive a higher premium than the acquiring shareholders as compensation for giving up control or for having a lower bargaining power. Finally, E) is incorrect because the required rate of return of a firm depends not only on its systematic risk (beta) but also on its total risk, which includes unsystematic risk and business risk. Even if two firms have similar betas, their required rates of return may still differ due to differences in their cash flows, growth prospects, debt ratios, and other factors.

Question 14

present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if it had no debt.

Accepted Answer

The present value of the free cash flows discounted at the unlevered cost of equity gives the value of the firm's operations assuming it is 100% equity-financed (i.e., no debt). Therefore, it is the value of the firm's operations if it had no debt.

Question 15

Which of the following are legal and acceptable reasons for the high level of merger activity in the U.Sduring the 1980s?

Accepted Answer

The answer of Which of the following are legal and...

Question 16

Coca-Cola's acquisition of Columbia Pictures and its announcement that it would operate its new subsidiary separately could be described as primarily a financial merger.

Accepted Answer

The answer of Coca-Cola's acquisition of Columbia Pictures and its...

Question 17

if a target firm's value is greater to the acquiring firm than its market value as a separate entity will a merger be financially justified.

Accepted Answer

If the acquiring firm values the target firm more than its market value as a separate entity, then the merger would create value for the acquiring firm and be financially justified. This is because the acquiring firm is able to benefit from the synergies created by combining the operations of the two firms.

Question 18

two-tier merger offer is one where the acquiring company offers to purchase the target company in a two-part transaction Cash is paid to some stockholders, bonds are issued to others, but the total values of each part of the transaction are equal.

Accepted Answer

A two-tier merger offer typically involves offering different terms to different groups of shareholders, often with a higher initial offer followed by a lower offer, rather than equal values for each part.

Question 19

goodwill created in a merger must be amortized over its expected life, usually 40 years, for shareholder reporting purposes.

Accepted Answer

Goodwill is not amortized for shareholder reporting purposes; instead, it is tested annually for impairment according to current accounting standards.

Question 20

distribution of synergistic gains between the stockholders of 2 merged firms is almost always based strictly on their respective market values before the announcement of the merger.

Accepted Answer

The distribution of synergistic gains is not strictly based on market values; it can be influenced by negotiation, strategic importance, and other factors.

Quiz 26: Mergers

Which of the following statements is most CORRECT?

rate used to discount projected merger cash flows should be the cost of capital of the new consolidated firm because it incorporates the actual capital structure of the new firm.

Which of the following statements about valuing a firm using the APV approach is most CORRECT?

Although goodwill created in a merger may not be amortized for shareholder reporting purposes, it may be amortized for Federal tax purposes.

Which of the following statements about valuing a firm using the APV approach is most CORRECT?

Discounted cash flow methods are not appropriate for evaluating mergers because the cash flows are uncertain and the discount rate can only be determined after the merger is consummated.

a financial merger, the relevant post-merger cash flows are simply the sum of the expected cash flows of the 2 companies, measured as if they were operated independently.

Since a manager's central goal is to maximize the firm's stock price, any merger offer that provides stockholders with significant gains over the current stock price will be approved by the current management team.

the capital structure is stable, and free cash flows are expected to be growing at a constant rate at the horizon date, then the horizon value is calculated by discounting the free cash flows plus the expected future tax shields at the weighted average cost of capital.

3 main advantages of holding companies are (1) control with fractional ownership, (2) taxation benefits, and (3) isolation of operating risks.

Which of the following statements is most CORRECT?

present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if it had no debt.

Which of the following are legal and acceptable reasons for the high level of merger activity in the U.Sduring the 1980s?

Coca-Cola's acquisition of Columbia Pictures and its announcement that it would operate its new subsidiary separately could be described as primarily a financial merger.

if a target firm's value is greater to the acquiring firm than its market value as a separate entity will a merger be financially justified.

two-tier merger offer is one where the acquiring company offers to purchase the target company in a two-part transaction Cash is paid to some stockholders, bonds are issued to others, but the total values of each part of the transaction are equal.

goodwill created in a merger must be amortized over its expected life, usually 40 years, for shareholder reporting purposes.

distribution of synergistic gains between the stockholders of 2 merged firms is almost always based strictly on their respective market values before the announcement of the merger.