Valuation of a Merger You own stock in Carpet City,Inc.,which has just made a bid of $165 million to purchase Tile Corporation.The two firms currently have cumulative total cash flows of $25 million which are growing at 2 percent annually.Managers 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 cash flows will grow at a rate of 3 percent.The merged firms are expected to have a beta = 1.75,the risk-free rate is 5.5 percent,and the market risk premium is currently 7.5 percent.Calculate the NPV of the merger.Will you vote in favor of the merger?

Question

Quizplus · Accepted Answer

1. Calculate the present value of the cash flows from the two firms:
PV of cash flows = $25 million / (0.055 - 0.02) = $577.35 million

2. Calculate the present value of the expected increase in cash flows for the first three years:
PV of increased cash flows = ($25 million * 0.04 * (1 - (1/1.04^3))) / (0.055 - 0.02) = $32.43 million

3. Estimate the terminal value of the firm after three years:
TV = ($25 million * 1.04^3) / (0.075 - 0.03) = $442.5 million

4. Calculate the total present value of the merged firm:
PV of merged firm = $577.35 million + $32.43 million + $442.5 million = $1,052.28 million

5. Calculate the total cost of the merger:
$165 million

6. Calculate the net present value of the merger:
NPV = $1,052.28 million - $165 million = $887.28 million

Since the NPV is positive, this suggests that the merger is expected to create value for the shareholders of Carpet City, Inc. Therefore, it would be advisable to vote in favor of the merger. Option A is the correct choice.

Valuation of a Merger You Own Stock in Carpet City,Inc