Blazer Inc. is thinking of acquiring Laker Company. Blazer expects Laker's NOPAT to be $9 million the first year, with no net new investment in operating capital and no interest expense. For the second year, Laker is expected to have NOPAT of $25 million and interest expense of $5 million. Also, in the second year only, Laker will need $10 million of net new investment in operating capital. Laker's marginal tax rate is 40%. After the second year, the free cash flows and the tax shields from Laker to Blazer will both grow at a constant rate of 4%. Blazer has determined that Laker's cost of equity is 17.5%, and Laker currently has no debt outstanding. Assuming that all cash flows occur at the end of the year, Blazer must pay $45 million to acquire Laker. What it the NPV of the proposed acquisition? Note that you must first calculate the value to Blazer of Laker's equity.

Question

Quizplus · Accepted Answer

To find the value to Blazer of Laker's equity, we need to use the following formula:

Equity Value = PV of Free Cash Flows + PV of Tax Shields

Year 1:

NOPAT = $9 million 
Free Cash Flow = NOPAT = $9 million 
Tax Shield = Interest Expense * Tax Rate = $0 
PV of Free Cash Flow = $9 million / (1 + 17.5%)^1 = $7.66 million 
PV of Tax Shields = $0

Year 2:

NOPAT = $25 million 
Free Cash Flow = NOPAT - Net New Investment = $25 million - $10 million = $15 million 
Tax Shield = Interest Expense * Tax Rate = $2 million * 40% = $0.8 million 
PV of Free Cash Flow = $15 million / (1 + 17.5%)^2 = $10.11 million 
PV of Tax Shields = $0.8 million / (1 + 17.5%)^1 = $0.68 million

Total Equity Value = $7.66 million + $10.11 million + $0.68 million = $18.45 million

Now, we can use the following formula to calculate the NPV of the proposed acquisition:

NPV = Equity Value - Cost of Acquisition

NPV = $18.45 million - $45 million = -$26.55 million

Since the NPV is negative, the acquisition is not a good investment for Blazer.