The managers of BSW Inc. have been approached by EAG Corp. for a possible merger. EAG Corp. is asking a price of $20.5 million to be purchased by BSW Inc. The two firms currently have cumulative total cash flows of $1 million that are growing at 3 percent annually. Managers of EAG estimate that because of synergies the merged firm's cash flows will increase by an additional 4 percent for the first three years following the merger. After the first three years, managers of EAG have estimated that cash flows will grow at a rate of 2 percent. The WACC for the merged firms is 8 percent. Managers of BSW Inc. agree that cash flows should grow at an additional 4 percent for the first three years, but are unsure of the long-term growth rate in cash flows estimated by EAG. Calculate the minimum growth rate needed after the first three years such that BSW Inc. would see this merger as a positive NPV project.

Question

Quizplus · Accepted Answer

To calculate the minimum growth rate needed for BSW Inc. to see the merger as a positive NPV project, we need to calculate the present value of all cash flows (including the purchase price) and compare it to the initial investment of $20.5 million.

Year 0: - $20.5 million (purchase price)
Years 1-3: $1.04 million * 1.04 * 1.04 * 1.04 = $1.144 million
Years 4 and beyond: CF4 = $1.144 million * (1 + g)
Discount rate = WACC = 8%

NPV = -$20.5 million + $1.144 million/(1.08)^1 + $1.144 million/(1.08)^2 + $1.144 million/(1.08)^3 + CF4/(1.08)^3

Solving for NPV = $0, we get CF4 = $1.214 million.

$1.214 million represents a growth rate of (1.214/1.144)^(1/2) - 1 = 2.82% (rounded to the nearest hundredth).

Therefore, the correct answer is choice B.

The Managers of BSW Inc