Smart Acquires Snazzy
Smart Products plans to acquire Snazzy Snaps,which will create $8 million in incremental cash flows for Smart each year for the first six years.Smart Products plans to divest Snazzy Snaps at the end of the sixth year for $112,500,000.Smart's beta (b)is 1.2,and is expected to remain so after the acquisition.The risk free rate is 5 percent and the expected return on the market is 16 percent.Smart Products has a 100 percent equity capital structure which will be maintained post-acquisition.
-Suppose Smart Products' stock price is $40 per share,and there are 12,000,000 shares outstanding.How many new shares must Smart issue to acquire Snazzy Snaps at the maximum price?

Question

Quizplus · Accepted Answer

First, calculate the cost of equity using the Capital Asset Pricing Model (CAPM): Cost of Equity = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate) = 5% + 1.2 * (16% - 5%) = 18.2%. Next, calculate the present value of the incremental cash flows and the divestiture using the cost of equity as the discount rate: PV = $8 million / (1 + 0.182)^1 + $8 million / (1 + 0.182)^2 + ... + $8 million / (1 + 0.182)^6 + $112.5 million / (1 + 0.182)^6. This calculation gives the total present value of the acquisition benefits. Assuming the total present value calculated is the maximum price Smart is willing to pay for Snazzy Snaps, divide this amount by the current stock price ($40) to find the number of shares Smart must issue to finance the acquisition. The correct answer suggests that the calculation based on these steps results in the need to issue approximately 1,727,255 new shares.

Smart Acquires Snazzy Smart Products Plans to Acquire Snazzy Snaps,which Will Create $8