Al's is analyzing the possible acquisition of Baker's. Both firms have no debt. Al's believes the acquisition will increase its total aftertax annual cash flows by $2.8 million indefinitely. The current market value of Baker's is $91 million, and that of Al's is $143.6 million. The appropriate discount rate for the incremental cash flows is 11 percent. Al's is trying to decide whether it should offer 40 percent of its stock or $104 million in cash to Baker's shareholders. The cost of the cash alternative is ________, while the cost of the stock alternative is ________.
A) $91,000,000; $90,824,141
B) $91,000,000; $104,000,000
C) $91,000,000; $91,338,092
D) $104,000,000; $104,021,818
E) $104,000,000; $103,837,209

Question

Quizplus · Accepted Answer

The cost of the cash alternative is straightforward; it is the $104 million offered. For the stock alternative, we calculate the cost based on the present value of the incremental cash flows. The present value of the incremental cash flows is calculated as $2.8 million / 0.11 = $25.454545 million. This represents the increase in value to Al's from the acquisition. The percentage increase in Al's value is $25.454545 million / $143.6 million = 0.1772727 or 17.72727%. If Al's offers 40% of its stock, the cost of the stock alternative is 40% of Al's value after the acquisition increase, which is 40% of ($143.6 million + $25.454545 million) = 40% of $169.054545 million = $67.621818 million. However, since the correct calculation method involves directly calculating the cost of issuing new stock based on the market value and the percentage offered, and not the incremental cash flow approach as mistakenly described, the initial explanation led to an incorrect calculation. The correct approach to find the cost of the stock alternative involves understanding that the stock alternative dilutes the current value of Al's shares by the percentage given to Baker's shareholders.

Al's Is Analyzing the Possible Acquisition of Baker's