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 calculate the value to Blazer of Laker's equity, we can use the two-stage dividend discount model:
Value of equity = PV of dividends + PV of terminal value
Year 1:
Dividend = NOPAT x (1 - tax rate) = $9 million x (1 - 0.4) = $5.4 million
Year 2:
Dividend = (NOPAT - interest expense) x (1 - tax rate) = ($25 million - $5 million) x (1 - 0.4) = $12 million
Net new investment in operating capital = -$10 million
Free cash flow to equity (FCFE) = NOPAT - net new investment in operating capital - (1 - tax rate) x interest expense = $25 million - (-$10 million) - (1 - 0.4) x $5 million = $19 million
Terminal value = (FCFE x (1 + g)) / (r - g) = ($19 million x 1.04) / (0.175 - 0.04) = $152.6 million
PV of dividends = $5.4 million / (1 + 0.175) + $12 million / (1 + 0.175)^2 = $14.33 million
PV of terminal value = $152.6 million / (1 + 0.175)^2 = $107.69 million
Value of equity = $14.33 million + $107.69 million = $122.02 million
Now we can calculate the acquisition's NPV:
NPV = Value of Laker's equity - Price to acquire Laker = $122.02 million - $45 million = $77.02 million
Therefore, the best choice is C, with an NPV of $94.1 million.