Juicers Inc.is thinking of acquiring Fast Fruit Company.Juicers has determined that Fast Fruit's current cost of equity is 17.5%; Fast Fruit currently has no debt outstanding.In Year 1, Juicers expects Fast Fruit to generate $9 million in NOPAT and invest $50 million in total net operating capital.Fast Fruit will borrow to finance this expansion, with the first interest payment ($5 million) due at Year 2.(There will be no interest due at Year 1.) In Year 2, Fast Fruit will generate $25 million in NOPAT and invest $10 million in total net operating capital.Fast Fruit's marginal tax rate is 25%.After the second year, the free cash flows and the tax shields each will grow at a constant rate of 4%.Assume that all cash flows occur at the end of the year.If Juicers must pay $90 million to acquire Fast Fruit, what is the NPV of the proposed acquisition? (Report your answer in millions of dollars.)

Question

Quizplus · Accepted Answer

1. Calculate the Present Value of Free Cash Flows (FCF) for Years 1 and 2
Year 1 FCF = NOPAT - Net Investment in Operating Capital x (1 - marginal tax rate)
Year 1 FCF = $9 million - $50 million x (1 - 0.25) = -$22.5 million
Year 2 FCF = NOPAT - Net Investment in Operating Capital x (1 - marginal tax rate) + Depreciation x marginal tax rate
Year 2 FCF = $25 million - $10 million x (1 - 0.25) + $50 million x 0.25 = $22.5 million

Present value of Year 1 FCF = -$22.5 million/(1 + 0.175) = -$19.15 million
Present value of Year 2 FCF = $22.5 million/(1 + 0.175)^2 = $17.96 million

2. Calculate the Present Value of Tax Shields (TS) for Years 1 and 2
Year 1 TS = Net Debt x Interest Rate x marginal tax rate
Year 1 TS = $50 million x 0 x 0.25 = $0
Year 2 TS = Net Debt x Interest Rate x marginal tax rate
Year 2 TS = $50 million x 0.1 x 0.25/(1 + 0.175) + $5 million x 0.25/(1 + 0.175) = $6.73 million

Present value of Year 1 TS = $0
Present value of Year 2 TS = $6.73 million/(1 + 0.175)^2 = $5.31 million

3. Calculate the NPV of the Acquisition
NPV = Present value of FCF + Present value of TS - Acquisition Cost
NPV = -$19.15 million + $5.31 million - $90 million = -$104.84 million
NPV is negative, meaning the acquisition would destroy shareholder value. Therefore, the best choice is NOT to acquire Fast Fruit Company.